Given the increasing drawdown in the market, it seems prudent to revisit the notion of volatility vs risk. For our original post, click here.
1) To recap, in case you just got back from a 10 day silent mediation retreat, S&P500 peaked on Feb 19th 2020, and has been in pretty much a free-fall since then, down almost 13%. Unless you were considerably short the market, these ten days did not feel good.
2) That bad feeling, usually associated with the stomach region, is Volatility.
3) By contrast, Risk, is the thing you do if you react to this Volatility based on that feeling instead of whatever asset allocation plan you had before the drawdown started. Here are two examples:
A) Your plan was to hold a 60% Stock 40% Bond portfolio for the long run, but by the end of last week you felt a very strong urge to sell some of the Stocks. You did not plan to do it before, but now, looking at the spreading anxiety, you feel that it was a prudent decision. That’s Risk.
B) Your plan was to follow trend following and your signals are now telling you to sell Equities. But by the end of the week, you feel bad about locking in the losses and worried about missing the reversal, so you override your model and decide to hold on. That’s Risk.
4) Notice how examples A and B result in an opposite bet. Investor A was planning to keep equity exposure, but decided to reduce it. Investor B was planning on reducing equity exposure, but decided to keep it.
5) Both of these investors have just created a “Gap” between their plan and their actions. This gap will grow over time and eat away at their returns. How large is this gap? Though difficult to estimate precisely, investors give up about 3% on average. In the case of multi-asset funds and endowments, the Gap can get as large as 6%! per year.
6) In sum, whatever your investment process was before Feb 19th, try to stick with it no matter if it’s “buying the dip”, “holding stocks for the long run”, or, as in our case, “Dynamic Asset Allocation” and “Focused Quality” investing.