A standard practice utilized by financial advisors is the completion of a risk questionnaire to help determine the proper allocation of assets in a portfolio. The theory is that investors have a comfort zone for risk and by utilizing tools like psychological assessments, an advisor can help an investor find that comfort zone and make good and committed decisions, resulting in a portfolio that will produce the returns necessary to achieve financial goals and sleep soundly. One of my beliefs is that although this is a good practice, it only scratches the surface.

I am going to address three different facets of this important concept: Risk, Volatility, and Turbulence.

What is Risk?

From Investopedia: " Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment."

We could add to this by suggesting that risk should always be measured over a specific timeframe. So if an investor has a Financial Plan stating a required long-term goal of achieving a +4-6% annualized net rate of return over a 5-year timeframe, risk is the chance that won't happen.

When you complete a risk tolerance questionnaire, you are judging your tolerance over your projected timeframe. Since December 31, 1999, the worst performance reporting period for the S&P 500 would have included 2008-2009, but the longer-term annualized average total return, say between Dec 31, 1999 - June 20, 2023 (time of writing) was +6.50% per year.

Over the last 5 years, and even with the turmoil resulting from COVID, the S&P 500 resulted in total returns of +11.59% per year (June 20, 2018 - June 20, 2023); given this data, equities really do seem like a relatively reasonable risk-to-reward investment.

What is Volatility?

So based on definitions, the problem is not risk, it's volatility.

Investopedia says: "Volatility represents how large an asset's prices swing around the mean price. Volatile assets are often considered riskier than less volatile assets because the price is expected to be less predictable."

When you look at volatility, your are generally looking at short-term metrics. A simple way to look at this is what stock market people call "Drawdown", which is how much an investment declined during periods of negative performance in the past. So if a stock dropped 30% during its worst period over the past five years, we'd say its 5-year "max drawdown" is -30%.

Compared to 5-year rolling returns, short-term volatility was much more exaggerated. During the 2008-2009 Financial Crisis, on March 9, 2009, the S&P 500 dropped 55%, and then during COVID on March 20, 2020, it dropped 34%.

 

So let's say that 10 years ago in June 2013, you set a goal of a 7% return, and your annualized return on the S&P 500 was +12.83% per year. You not only achieved and greatly exceeded it BUT in order to do so during this time period, you experienced the discomfort of a 34% max drawdown. The end result was positive, exceeding your goal by an additional 5.83% for the 10-year period. The question is, how did you manage the volatility when your $1 million portfolio fell by $340,000? Based on definition, you were OK with the risk and return but the volatility was uncomfortable.

What is Turbulence?

The third concept doesn't really have a financial definition. Think of turbulence on an airplane flight to your favourite destination. Most flights experience some degree of turbulence, which is normal. Most of the time, you just ignore it and read your book, watch the movie, or engage in conversation with someone you just met. Other times, you grip the armrest, like that is going to provide you with some level of safety, and white-knuckle until things settle down. By the time the flight lands, you've achieved your goal of safe arrival at your destination. There was a small degree of risk (1 in 11 million based on an internet search):

"During a flight at cruising levels, only about 3% of the atmosphere has light turbulence, about 1% has moderate turbulence, and a few-tenths of a percent have severe turbulence at any given time," says Paul Williams, Professor of Atmospheric Science at the University of Reading.

Other than when buying a GIC or government bond, you are guaranteed to experience some degree of "turbulence" in an investment portfolio. COVID threw your best laid plans in flux, and recovery from COVID and central bank activity has caused many bumps.

Your goal in structuring an investment strategy is to set your longer-term goals based on longer-term risks with the understanding that there will be turbulence that you can tolerate. Jumping out of the airplane during turbulence is never a good strategy!

Final Thoughts

Most people don't have 100% equity portfolios. If you had a 60% equities / 40% fixed income strategy, which hasn't been the best during the past year because bonds performed poorly in 2022 but we'll use it as a standard benchmark (by comparing the 60/40 Vanguard Balanced ETF VBAL.TO), your worst max drawdown in 2022 was 17.29% vs the max drawdown on the S&P 500 of 24.49% (on October 12, 2022), so as an investor you experienced somewhat more tolerable volatility.

The problem is that people hold a 60/40 portfolio but watch the equity component like they were 100% equities. When you hold equities in a portfolio, it is important to play a strong mental game. Pick a long-term goal and give it time. Focus on high-quality companies with consistent and predictable earnings growth and positive cash flow which are trading at reasonable prices and diversify. Don't let short-term performance excite you during positive markets or depress you during negative periods.

"It is better to be approximately right than precisely wrong."

~ Warren Buffett, on investing

 

Maybe you can't tolerate equity turbulence, and that's OK too. You may want to look for more appropriate asset classes, but always understand the concepts presented to you, and don't let fear of the unknown cloud your investment decisions.