Re-Evaluating Risk for Long-Term Investors
In 2010, I started work as a financial advisor for a major Wall Street firm. I thought that after spending most of my life in dealing rooms, the transition to the client-facing side of the business would be pretty straightforward. However, as I prepared to pass my Series 7 exam, a requirement to sell securities in the U.S.*, I realized that wasn’t true. To pass the exam, I had to relearn a lot of things.
Primarily, the difference was that Series 7 required answers based on what should be, rather than what my decades of experience showed me it was. One of the most impactful of those lessons, particularly as it concerned how I dealt with clients and the advice I gave, was the nature of volatility and how it relates to risk.
The Series 7 material was clear: Volatility was bad. For traders and brokers inside the business, though, volatility is a good thing. Movement is essential if you are going to make money. The direction doesn’t matter, but the more a traded thing moves, the better. There was risk there, of course, but that was something to be managed and minimized, not to be avoided.
For a big broker in 2010, who was probably being sued by clients angry at losing money in 2008/9 as the market collapsed, however, volatility was the devil. We were taught to avoid it, and to carefully tell our clients how we were going to try to do that. The implication was that if we could avoid volatility, we could effectively avoid risk.
The problem is that the two things are not the same, something that is clearly demonstrated by looking at both stocks and bonds as investments over the last few years. Typically, advisors will tell you that you should have some bonds in your portfolio to lower both volatility and risk but if you started investing five years ago, bonds didn’t help in that way at all. During that time period, you would have seen the value of your stock holdings plummet as Covid gripped the world, then bounced back again quickly to above where they started. That is the definition of volatility, but the end result is a fairly decent return.
However, while the bonds that you bought may have reduced volatility in the short term as Treasuries actually gained a bit in the spring of 2020, they have been falling in value consistently. For example, TLT, the long-term Treasury ETF, is down more than forty percent since that high:
With the benefit of hindsight, it is clear that while buying bonds did reduce the overall short-term volatility in your portfolio, it didn’t reduce the risk. In fact, it increased it. Nor was that hard to understand at the time, really. You were buying bonds at a time when interest rates were hovering around zero. It was pretty likely obvious to many that rates would go up from there, pushing bond prices down. You were, in effect, buying something that was almost guaranteed to lose money, ostensibly to protect your investment. Call me a cynic if you will, but that doesn’t seem to make sense to me!
And yet, many advisors, having been taught when they started that volatility and risk were interchangeable terms, were still advising people to hold some bonds in their portfolio 5 years ago with interest rates at basically zero. Worse still, they were telling those who were close to retirement that they should hold a higher percentage of bonds to reduce said volatility.
The last twenty years or so has shown that for most people, whose investing time horizon is measured in multiple years or decades, attempting to avoid risk by reducing volatility is a bad idea. That is because of the nature of volatility. Advisors are taught that volatility involves a risk of downward movement, which of course it does, but a volatile asset moves to extremes in both directions, not just down.
So, when the bounce back comes, as it inevitably does, your holdings in things like ETFs that track the Nasdaq, say, or the Russell 2000, will bounce faster and higher. The net effect is that your “volatile” assets will always do better over long periods of time, assuming, of course, that stocks gain in the long run, as they have since the stock market began.
Over the last decade, the “safe” investment TLT has lost around 10%, while the stock index that is considered the least volatile and “safest” of the big three, the Dow, has gained around 120%. The more volatile Nasdaq-100, on the other hand, has gained close to 360%. One could argue that this has been an extraordinary decade with the advent of mobile computing, EVs and now AI, but that is exactly the point. We live in an age of rapid advances in technology and an investment portfolio has to reflect that if you are to take advantage. If that means accepting volatility, so be it.
The point here is obviously not that you should go out and convert everything to the riskiest assets you can find. "Risk," at least in the sense of the existential risk in something like, say, coal stocks, or the risk that comes with a badly-run company, is still not a good thing.
However, you must understand that while volatility exaggerates the risk in things that are risky, the two terms are not the same. The next time an advisor talks to you about reducing or avoiding volatility, ask them what that would have meant for overall returns over the last twenty years, or however long you intend to stay invested. You might be surprised by what the numbers show as opposed to what conventional wisdom assumes. Unfortunately, there is a good chance that your advisor will be surprised too.
* I should point out that while I passed the exam at my first attempt, I have since left the financial advising business, so I no longer hold a valid Series 7 qualification.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.