As a financial planner for over 6 years, one of the things that really frustrates me is poor explanations, as well as implications, of certain financial terms. The confusion it stirs up causes well-meaning investors to make poor decisions that cost them in retirement, and in some cases, cause them to end their retirement and go back to work.
One of the most dangerous misunderstandings is that risk is the same thing as volatility. As well as not fully understanding what each of those terms really mean.
If you think that those are the same things, or if you’re not sure how it can play into your retirement (which it absolutely does), then let’s clear up these major misconceptions and clarify the difference between risk and volatility so that you don’t make any major mistakes that derail your retirement.
Understanding the difference between risk and volatility
Volatility is how much a stock or fund price goes down or up over a period of time.
By looking at that definition, we can see that volatility works both ways – the stock price can go down by a lot, or it can go up by a lot. Those are both examples of volatility.
For example, the stock market might be up by 30% one year and down -10% the next. What we have been taught, especially when you listen to the media, is that the negative year is when it was volatile. On the contrary, both swings were volatile, yet we only complained about one.
So that’s volatility, now let’s talk about the definition of risk.
According to Investopedia, risk is the chance that an investment’s actual gains will differ from its expected returns.
Included in that definition, and this is key here, is that risk means the possibility of you losing most or all of your initial investment. If you do other searches for risk, you’ll see some people say that risk is the permanent loss of capital. So that is a major theme to what most people define as risk.
Based on that definition, can we say that the stock market is entirely risky? In other words, is it possible to lose all of your initial investment? For instance, if you buy a low cost index fund like the S and P 500, and you put $1,000 into it, will your investment go to 0?
In my opinion, as long as you follow a disciplined investment strategy, as well as avoid key behavioral mistakes like managing your investments with your emotions, then no, that isn’t going to happen.
Outside of that, the only way the S and P 500 could go to zero is if all of those companies shut down and ceased to exist. Which, frankly, if that were to happen would mean we were in the middle of armageddon.
Over the past century, the US stock market, represented by the S&P 500, has yielded average returns of roughly 10% per year. If you had invested $1,000 in the S&P 500 100 years ago you’d now be worth $13 million from that investment alone.
Of course, during that time there was a lot of volatility, a lot of ups and downs. For some periods, the downs last five or more years. But did it ever go to 0? No. And if you held on through those down periods, did the markets (and thus your investment) recover and eventually hit new highs? Absolutely!
So looking at the historical performance of stocks, I simply don’t see how there’s any permanent risk of losing your capital, unless you make those emotional and behavioral mistakes which cause you to buy and sell at the worst possible times.
Again, if you can stick to a tried and true investment strategy of buying a well diversified, low cost portfolio, I think your risk, in the traditional sense, is quite low.
To sum up, volatility is the swings that your investments will go through, both positive and negative. And the traditional definition of risk, that you will have a permanent loss in your portfolio, is quite low, if you follow a solid investment strategy.
But I don’t actually think that that is the best definition of risk. In my mind, the true risk that retirees face is not whether their portfolio is volatile, or that they will experience a permanent loss in their portfolio.
The biggest risk in my mind is that in future years (and especially decades), you will have a loss of purchasing power, and your investments won’t be able to buy you as much in the future as they did at the start of your retirement.
Let’s talk about how that could happen as we discuss…
Three important things to know about risk vs volatility
- Retirees lose money by making “safe” investments
It is a well-established (and acceptable) fact that as we age we become more risk-averse. It makes perfect sense to make different, and less risky, decisions as you get older. However, this becomes a problem when people confuse risk with volatility.
As a result of this misunderstanding, a lot of retirees make the mistake of thinking that in order to make their investments safer, they need to get rid of volatile assets. And so, they dump all or most of their stocks and replace them with bonds.
Bonds should be a part of most everybody’s portfolio in retirement. However, they should never be the only thing in your portfolio!
While bonds give slow and steady returns and are not nearly as volatile as stocks, the returns are low. If you’re getting 3% to 4% from your bonds, inflation is 2.5% – 3% and you’re withdrawing at least 4% each year, you could be setting yourself up for disaster if you’re dipping into your principal too quickly, and increasing the chances that your portfolio isn’t there later on in your life.
By making your investment less volatile, you have actually made it increasingly risky, because you’re putting your older version of yourself at risk of not having the income you need later on in life.
- The risk of bonds vs the risk of stocks
Bonds bring stability to a portfolio. They give you the assurance that your principal won’t move too much, which is different from the unpredictable and volatile nature of stock returns. You also get similar comfort when investing in money markets funds or certificates of deposit (CDs).
When you invest in stocks, you accept the higher volatility levels. While it is unpredictable, investment returns historically have been two to three times as much as bonds. Stocks also enable you to grow your money and can boost your purchasing power overtime. These investments should help you increase your spending each year without running out.
While bonds provide a measure of certainty, they can’t increase your purchasing power much. That is why the volatility of stocks is just what your retirement plan needs. As a number of financial experts have pointed out, one reason why equities get substantially higher returns is the volatility that they go through. Volatility is simply the price we pay for getting higher returns.
More often than not, volatility is in fact a blessing. Those who favor bonds over stocks miss out on the benefits of volatility, which is those much higher returns, and that is a risk not worth taking with 100% of your portfolio.
- The biggest risk retirees face is not volatility
If risk is defined as the loss of purchasing power, and not volatility, then the biggest risk retirees face is not having enough stocks in their portfolio.
Put differently, the biggest risk you face is that your purchasing power does not provide you the income you need in your late 70s, 80s, and 90s.
A retirement nest egg should last throughout your golden years. Any investment that will cause you to run out of money or consistently lower your annual withdrawals (ie, your income!), especially later on in life when you don’t want to go back to work, is a risk you need to minimize.
So the fact that your investment accounts are unpredictable and inherently go up and down is not the biggest problem. Again, the biggest problem is that you won’t have the purchasing power you need later on in life, and the best way to mitigate that worry is to have a solid allocation of stocks, and not go overboard on your bond allocation.
Conclusion
While there is some overlap between risk and volatility, they are akin to apples and oranges. The more you study the differences, the more you realize that volatility can actually be the solution to unnecessary risk in retirement.
So, if you plan on maintaining a decent standard of living in retirement, it pays to use a financial adviser that knows the truth about the real risk you face in creating a retirement income that will last for life.
But enough theory. If you would like to see what this would look like in reality and the kind of service we offer, go to StartMyRetirement.us and we will create a one-page retirement plan for you that will outline everything you need to do to have your retirement money last as long as you do.