Think you can stomach the stock market's volatility?

If you’ve ever followed our blog or are a client of ours then you know one of our favorite terms:  volatility. Volatility is the price fluctuation of a given security over certain periods of time.  Every investment has volatility.

Sometimes people think our only job is to make them money by purchasing the securities that are destined to increase in value, but a large portion of our job is educational in nature. In this article we will cover security volatility and what is appropriate for certain investors.  Then we will discuss some common trends/educational opportunities we discover from our conversations with prospects. We hope this article will give you insight into your own risk tolerance and the types of investments you can stomach!

Volatility Quantified

We have to be on the same page with our clients when it comes to understanding volatility.  Because, volatility-expectations and therefore potential returns are directly related. To set a level playing field, we use Riskalyze to apply quantitative metrics to volatility and potential returns.

Riskalyze ranks the universe of stocks, ETF’s, and mutual funds against one another to compare apples to apples. Simply put, a holding with a higher risk number is more aggressive than one with a lower number. The higher the number, the wider the range of historical volatility of the security.  In addition, Riskalyze analyzes historical returns against volatility and gives some insight into which investments may (may being key here) provide a better risk/reward ratio given the same risk via the GPA scorecard.

Here are some quick comparisons for reference and to guide the rest of this article:

SPY and VTI are two extremely broad based ETF’s that are great barometers of the entire stock market. The SPY actually follows the 500 stocks inside of the S&P 500 index and the VTI is the total stock market index by the largest ETF company in the world, Vanguard. These two ETF's diversify across a large number of companies, so you can image how single companies span the gamut in terms of risk score. Here are some fun facts with generalized risk scores.  (If you're ever curious about a specific securities risk number please reach out to us for a one on one where we can show you more specific numbers.)

The 10 largest market cap companies in the US are all above an 84!

The lowest Risk score for an Arkansas based company is 74!

Corporate bond funds are generally 25-50 on the risk score. 

Your Risk Number

One of the first steps we walk people through is a Risk Tolerance Questionnaire(RTQ).  Riskalyze uniquely adapts a person's risk tolerance to match this quantitive scale of risk. A ‘Risk Number’ is calculated, which sets the target 'acceptable volatility'.  Here is an example of some different risk scores a prospect can generate.  (In this example we use a baseline investment amount of $1,000,000)

(95% Historical - is simply the range of fluctuation that will occur 95% of the time over the next 6 months. This means that if your account was outside of this range within the next 6 months, then it is a 5% anomaly.)

Riskalyze analyzes the entire construct of portfolios, weighting holdings inside that all have varying individual risk scores. So, our job isn't to magically buy securities destined to increase in value, BUT to construct a risk appropriate portfolio to provide you with the optimal risk/reward potential.  Most portfolios are blended with stocks, mutual funds, etfs, and occasionally bonds in order to match questionnaire scores.  Where Riskalyze comes in handy is proving to clients that normal portfolio movements are both upward and downward. 

Trends and Misconceptions

One trend we have noticed when people complete the RTQ is that the larger the ‘investable amount’ entered into Riskalyze, the lower the risk level a person will score on the questionnaire.  Our belief is that when someone follows this trend, they are focused more on the dollar amount of fluctuation instead of the percentage fluctuation.  Notice how easy it is to nonchalantly up the risk score when the investable amount is only $10,000. People generally find the prospect of losing $4,232 more palatable than losing $423,200 (in the million dollar example).

A second trend we notice is that people will land in the range of 40-60, and then want to talk about investing into individual stocks of high growth tech names they've read about or have seen on CNBC.  This contradiction lies in the fact that many people do not understand the inherent risk associated with individual stocks.  Their focus is on the past performance of individual stocks instead of on the volatility those stocks experience.

The last trend occurs after someone has moved from a prospect to a client.  Occasionally, we will have a completed RTQ, an account invested to match their risk objective, and then a person who wants to compare their account to a much higher risk portfolio or benchmark. We call this ‘client selected benchmarking’.  If you look back at the 95% historical volatility window of the 51 compared to the 80, you’ll see the problem. Perhaps the market (SPY of 74) has moved 26% (up $260,000) but the account (a 51) has only moved up 16% ($160,000) in 6 months.  This person wants more return just because the movement of the market has already occurred. But, they are comparing their return to a much riskier ‘risk number’, and not to the one they told us they were okay with.  We have to lead our clients into understanding you don’t get to BE a 51 but want 80 returns.  Riskalyze sets the level field, where we can talk to our clients 6 months later and if the portfolio is within the 95% historical probability window, we give each other thumbs up!

Summary

Volatility is tough to comprehend without experiencing it yourself, but when embraced it can lead to confident and calculated decisions. When you're expecting the declines to come with the advances you won't be surprised!  Our job is to make sure you are confident in your investment plan, and that starts with the risk level you're comfortable stomaching. We would love the opportunity to talk with you about your risk number. Please fill out our questionnaire and you will hear back from us!  

**The performance data quoted represents past performance and does not guarantee future results. Current performance may be lower or higher. There is risk associated with these investments and nothing on this page is to be misconstrued as a recommendation.