Do you know the difference between % and $? Some investment organizations are hoping you don’t.
When making a case that short-term investing is more risky than long-term investing, it’s traditional for organizations to discuss volatility, or percentage change (%). For example, an investment firm might say, “These [exhibits] show clients they may encounter a fairly wide range of results as they move forward with their investment strategy, particularly over short time periods. They can also see, as time moves forward, that the expected range of returns narrows and the probabilities of reaching their objectives improve.”
This declining volatility (%) can be defined as the standard deviation of a portfolio. For example, in the short run, the standard deviation might be 20%, meaning that, within a reasonable market environment, one could make or lose 20% on an investment. However, as a portfolio ages or as time passes, the standard deviation falls. Maybe after twenty years or so, the standard deviation falls to 5%. Over time, the portfolio is less risky in that, within reason, the original portfolio value will fluctuate between plus or minus 5% as opposed to plus or minus 20%.
Investors presented with this information feel better because they see that the longer they hold their portfolios, the lower volatility will become, and they believe that lower volatility will translate into more favorable returns. They are told: “Once clients understand their investments are expected to deviate from average annual return targets, they won’t be as concerned when a return temporarily drops below them, particularly when it is still within the range they expected from the beginning.”
But there is one important variable left out in this explanation: the $. In other words, rate of return — or volatility — has been expressed in terms of %, not $.
What can be critical to an investor is absolute return, not percentage volatility. For example, in an investor’s early years, a portfolio is likely to be small. Over time, the value is likely to increase. So, using the selling pitch above, the individual who has $10,000 invested could experience a 20% swing in value in the short-term but, by the time the portfolio has matured, let’s say has grown to $500,000 near retirement, the volatility has fallen to 5%.
If you calculate the $ fluctuation rather than the %, the picture changes dramatically. The 20% risk amounts to $2,000 on a $10,000 portfolio. However, the apparently lower 5% risk on the long-term portfolio amounts to $25,000 — a $ increase in risk of more than 12 times.
In other words, as % decreases over time, the $ risk increases over time.
A second problem arises from the fact that the $500,000 portfolio, as with any portfolio, is exposed to short-term risk — i.e., that the portfolio can experience that 20% fluctuation this year. While the long-term analysis is soothing, there is always short-term risk to a current portfolio.
This was not an exercise in figuring out what politically incorrect language is all about. It was a critical evaluation of a deceptive marketing strategy — one that is widely used by investment organizations — that distorts the long-term rewards and risks of investing in equities.
The bottom line is that investors should be sensitive to both short- and long-term risk analysis, recognizing that a systematic strategy to reduce risk over time can become the critical strategy determining future savings. Life-cycle investing, using multiple portfolios with different risk/reward characteristics, can be one strategy that achieves this goal.
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc., and an investment consultant for Wealth Management Services of South Carolina.