The first thing we are taught in economics is that there is no free lunch. As it relates to finance, this means that, in general, higher returns can only be realized by taking more risk. Volatility is essentially the cost of the financial market buffet. Yet volatility is a dirty word, and the holy grail for us as investors is constructing a portfolio that can deliver outsized returns with minimal risk. Higher-volatility periods are usually associated with weaker coincident equity returns (though this is not always true), so we are preprogrammed to fear volatility. But in reality, for long-term investors, volatility is only as dangerous as you make it.
Intro to volatility
Volatility can be defined in any number of ways, including standard deviation, value at risk, max drawdown, and more (see sidebar at the end of this article), all of which essentially quantify the risk taken in a given investment or portfolio. The most oft-cited measure of volatility is standard deviation, though this is a challenging concept for most people to get their arms around. It is also not necessarily aligned with how investors may think about risk in their portfolios. For example, a particular investor may be less concerned with how much their portfolio return is likely to fluctuate in a given year (a measure consistent with standard deviation) and more focused on the maximum they could stomach losing at any given time—a concept we feel is often a better measure of risk and one that is reflected by the maximum drawdown. Part of our job is homing in on the specific measure or set of measures that resonate with investors as part of gauging their appropriate risk tolerance.
Please see important disclosures at the end of the article.
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