Updated January 3, 2023
Volatility is one of the least understood measurements of investment risk. In simple terms, volatility is the price swings.
Or, in a more clinical language, it’s an asset’s degree of price movement within a set period compared to another asset or to its price history.
The bigger and more frequent the price swings, the more volatile the market or stock is said to be. For example, a stock trading between $20 and $40 is considered more volatile than one trading between $25 and $30 during the same period. Similarly, a stock that traded between $25 and $30 in 2020, then between $20 and $40 in 2021, has increased its volatility.
Volatility and retirement portfolios
Volatility may be a trader’s paradise, but it is a retirement saver’s nightmare due to its uncertain impact on his or her savings’ ending value.
A useful analogy is to think of the retirement fund like an apple orchard of a farmer. The annual crop of apples is like the retirement income from the fund: More apples harvested means higher income from the retirement fund.
In this context, volatility is akin to violent windstorms and heavy weather during the growing season. Each time a strong wind blows, the apple trees shake, and apples fall to the ground. That diminishes the size of the harvest.
Plus 10%, minus 10% = no change? Why this is wrong
People often underestimate the effects of volatility on a portfolio over time. They assume the same percentage swings up and down are equal and have no impact on a portfolio’s value. For example, a price decline of 10% followed by a price increase of 10% would appear to “even out.” The values before and after the changes would be the same.
Unfortunately, the math doesn’t work that way.
This table illustrates the effect of five cycles of price declines and price increases of 10%, 20%, 30%, and 50% from a beginning value of $100. Since the decreases and gains are the same percentage, it could seem the ending value would equal the starting value ($100).
As shown in the table above, that is not the case.
In each example of volatility, the ending value is less than the beginning value. But as volatility increases, so does the decline in the savings’ ending value. If your stocks are seesawing in your savings, your apples are falling off your tree.
Volatility’s double whammy: inflation
Focusing on the potential losses from volatility, people often overlook the loss of purchasing power in a portfolio due to inflation. Inflation exaggerates the potential losses due to volatility. The following table illustrates the possible effects of multiple volatility rates and inflation rates over three years.
For example, retirement savings equal to the purchasing power of $100 experiencing 10% volatility and a 2% inflation rate would lose $11.50 in purchasing power over the period (11.5% loss in total value).
Higher volatility and inflation rates compound the losses in purchasing power. Getting back to the purchasing power of three years prior with 30% volatility and 7% inflation requires a doubling of the portfolio value.
Diversifying with gold can help reduce volatility
Gold ownership is a popular strategy to reduce volatility risk in savings because it is considered a hedge that has been especially sought out when financial markets are uncertain. There is economic research claiming gold is an asset with no market risk. Gold prices have risen when a national currency was considered unstable or when inflation worries grew.
Many portfolio managers purchase gold to lower equity volatility and hedge against stock markets declines. While gold can exhibit short-term price fluctuations due to unusual market conditions, it is less volatile: If the price of gold declines along with other asset classes, the precious metal historically has declined less than other assets.
The chart below shows the average daily volatility of various asset classes over the last five years, with gold being one of the least volatile assets.
Historically, when stock prices fell, the price of gold rose in most cases. In the rare times when the value of both assets declined, gold often retained a higher proportion of its value than securities.
These characteristics suggest that acquiring gold could notably reduce volatility without significantly lowering overall returns. And gold might potentially grow wealth if these gold price predictions for 2023 come true.
Understanding volatility is critical
We all know we want to reduce risk, and the professionals that help us are supposed to be doing just that. Being aware of volatility and knowing that reducing it will help your savings is a way you can relatively and easily monitor how balanced your savings are. As the famous economist Paul Samuelson once said:
“Investing should be like watching paint dry or grass grow. Manage your risks, and you’ll need a lawnmower.”– Paul Samuelson
May you be well and safe in these uncertain times.