T
he inherent nature of capital markets is
that they are volatile to varying degrees.
Understandably, whipsaw market conditions
are a source of investor anxiety. In such
environments, the natural bias is to limit
volatility, which can help prevent a loss in
portfolio value and preserve capital.
Understanding
Your objectives—and the amount of risk
you are willing to tolerate to achieve
them—are at the heart of our philosophy
as fiduciaries.
What is volatility and how is it defined?
Volatility, or risk, is an inherent aspect of capital markets and typically is defined as standard deviation. Standard deviation is a mathematical representation of how much variation exists from an average. A small standard deviation means that a set of data points are tightly knit. A large standard deviation means that a set of data points are spread out over a broad range. Visually, you may know standard deviation as the “bell curve.” Dispersion and variance are also common financial terms used to define volatility in capital markets.
Why would volatility influence your portfolio decisions?
Volatility is a useful tool that can help you set expectations for possible outcomes. For example, since 1926 and using annual data points, the S&P 500 has experienced 20% volatility.1 If we use a long-term average return on the S&P 500 of 12%, you can reasonably anticipate a range of outcomes from an 8% loss to a 32% appreciation over a one-year period and approximately two thirds of the time. Put another way, this represents a range of returns +/- 20 percentage points over or under the average, or, within one standard deviation of the series average. The given range of possible outcomes is an important variable in determining risk tolerances.
How can volatility affect the outcome of your portfolio?
Another way of looking at the problem is by demonstrating how volatility can erode wealth over time. The table below depicts two portfolios with a beginning value of $10 million, and both averaging an 8% return annually, over a 10-year time horizon. As you can see, Portfolio 1 generates approximately $2.2 million more than Portfolio 2 due to the consistency of returns.
Volatility Can Diminish Wealth
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Avg. Annual Return
Portfolio 1
Balance ($ Millions) $10.0 $10.8 $11.7 $12.6 $13.6 $14.7 $15.9 $17.1 $18.5 $20.0 $21.6 8.0%
Portfolio 1 Returns N/A 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Portfolio 2
Balance ($ Millions) $10.0 $11.2 $11.7 $11.7 $13.5 $12.2 $15.3 $15.6 $17.8 $14.3 $19.4 8.0%
www.atlantictrust.com Page 3 Understanding Market Volatility
Are investments worth the volatility?
Typically speaking, the more volatility an asset class experiences, the more return is expected from that asset class over time. As you can see below, the long-term returns of equities have outpaced those of cash, corporate bonds and government bonds. However, it is important to note that the equity returns are not without excess volatility. For instance, large-cap stocks on average have nearly double the annual return of corporate bonds. By comparison, large-cap stocks have also nearly twice the volatility. Similarly, small-cap stocks have averaged annual returns nearly three times that of corporate bonds but, comparatively, have almost four times the volatility. Typically, the investment can be worth the volatility, but the time horizon is equally as important as the expected gains. Meaningful appreciation over longer time horizons has proven to offset short periods of volatility and loss of portfolio value.
Volatility Can Diminish Wealth
$21.6 $19.4 $10 $13 $16 $19 $22 $25
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Portfolio 1 Portfolio 2
Source: Strategas, December 31, 2011. For illustrative purposes only.
Asset Class Breakdown (%)
For Illustrative purposes only.
Since Inception*
1925 - 2011 Last 30 Years1981-2011 Last 20 Years1991 - 2011 Last 10 Years2001 - 2011 Last 5 Years2006 - 2011 Average
Return DeviationStandard 30-YearReturn DeviationStandard 20-YearReturn DeviationStandard 10-YearReturn DeviationStandard Return5-Year DeviationStandard
Should you use volatility to time the market?
While anticipating volatility is common, using volatility to predict market behavior is difficult, because information is typically imperfect and idiosyncratic. As an example, just because a market falls 10% doesn’t mean it won’t fall another 10%. Similarly, waiting for a “better” entry point because a market has appreciated can work against you, because the market can appreciate further. Ideally, you will take advantage of mispricing events in capital markets to add value over time. However, attempting to “time the market” in the short term is a risky proposition—where the opportunity cost is quantifiable and not likely to be in your favor. The following graph illustrates the risk of trying to time the market:
Investments in the U.S. Capital Markets Year-end 1925 = $1.00, through year-end 2011
$0 $1 $10 $100 $1,000 $10,000 $100,000 1925 1935 1945 1955 1965 1975 1985 1995 2005 Small-Cap Stocks Large-Cap Stocks Corporate Bonds Gov't Bonds T-Bills (Cash)
Source: Strategas, December 31, 2011. This is a logarithmic chart and may be more effective than other types of charts in illustrating changes in value during the early years shown in the chart. The vertical axis, the one that indicates the dollar value of an investment, is constructed with each segment representing a percent change in the value of the investment. In other words, the space between $1 and $10 is the same size as the space between $10 and $100, and so on.
S&P 500 Index Returns
Source: Strategas, December 4, 2012. *Estimate. Past performance is not a guarantee of future results. An investment cannot be made directly into an index.
-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 2009 2010 2011 2012*
www.atlantictrust.com Page 5 Understanding Market Volatility
(trading days) chance that you’ll pick the direction and timing—accurately—when the impact is greatest. The odds are heavily stacked against you if that is your discipline. While it is tempting to think you can accurately predict this behavior through past experiences, the reality is that investing in such a manner is irrational.
What can you do to harness volatility?
Atlantic Trust’s philosophy is that discipline and diversification are critical building blocks in any investment process. Without a framework for a long-term investment program, the chances of success are relatively small. Constructing a portfolio with a broad array of asset classes is critical to generating consistent, less volatile returns, which can facilitate capital growth and preservation in the long term.
However, even the most diversified and well thought out portfolios are subject to volatile markets. Our investment professionals and relationship managers ensure they maintain an active management bias. This bias provides us with the flexibility to manage asset allocation and manager selection within the constraints of client guidelines as opportunities present themselves.
www.atlantictrust.com Atlanta 404 881 3400 Austin 512 651 7800 Baltimore 410 539 4660 Boston 617 357 9600 Chicago 312 368 7700 Denver 720 221 5000 Houston 832 941 5760 Newport Beach 949 660 0080 New York 212 259 3800 San Francisco 415 433 5844 Washington, D.C. 202 783 4144 Wilmington 302 884 6775
Follow us on Facebook: AtlanticTrustPWM, Twitter: @AtlanticTrust and
LinkedIn: www.linkedin.com/company/atlantic-trust
Atlantic Trust Private Wealth Management, a CIBC company, includes Atlantic Trust Company, N.A. (a limited-purpose national trust company) and AT Investment Advisers, Inc. (a registered investment adviser), both of which are wholly-owned subsidiaries of Atlantic Trust Group, LLC.
This document is intended for informational purposes only, and the material presented should not be construed as an offer or recommendation to buy or sell any security. Concepts expressed are current as of the date of this document only and may change without notice. Such concepts are the opinions of our investment professionals, many of whom are Chartered Financial Analyst® (CFA®) charterholders or CFP® professionals. Chartered Financial Analyst® and CFA® are trademarks
owned by CFA Institute. The Chartered Financial Analyst® (CFA®) designation is a globally recognized standard for measuring the competence and integrity of
investment professionals. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the U.S., which
it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.