by C. Thomas Howard, Ph.D.; and Craig T. Callahan, DBA
C. Thomas Howard, Ph.D., is CEO and director of research at AthenaInvest Advisors, LLC. Craig T. Callahan, DBA, is president of ICON Advisors, Inc.
Imagine yourself en route to Paris, France, on a long awaited vacation when you hear this announcement:
"This is your captain speaking. I want to apologize for the air turbulence for which I've turned on the fasten seatbelt sign and asked the flight attendants to discontinue cabin service. Pilots at other altitudes have also reported bumpy air, so I've decided to land the plane in Omaha in order to avoid the turbulence rather than continue to our original destination of Paris. I hope you are able to find comfortable accommodations after we land in Omaha."
What a disappointment! Omaha, with all due respect to Warren Buffett, seems a poor substitute for Paris. Even though bumpy flights are unpleasant and sometimes even scary, a pilot choosing to land to avoid air turbulence would elicit the universal wrath of all onboard.
Although airline pilots are trained to persevere through air turbulence, many investors and their financial advisers are seemingly overwhelmed by market volatility. As with our panicked pilot, nervous investors all too often steer portfolios away from the highest expected returns available. Rather than accept volatility as part and parcel of investing, investors ask for low volatility portfolios that end up short of their final destination.
Catering to client demand for a smooth ride, financial advisers build portfolios to match client tolerance for volatility. Calibrated in countless ways, "volatility tolerance" thus drives investment objectives. Inevitably this translates into prorated equity exposure known as "moderate" or "conservative" portfolio allocations. Going further, many financial advisers subscribe to market timing or other hedging strategies to mitigate volatility. Yet all of these approaches significantly impair long-term performance and entail significant opportunity costs.
For better or worse, there is no substitute for remaining seated with your seatbelt fastened tight and low across your lap. Much as air travelers accept air turbulence as unavoidable in order to garner the benefits of flying, so investors should keep volatility in perspective and largely accept it as an inescapable dynamic in pursuit of superior long-term returns. Easier said than done, you might be thinking. Perhaps we can learn something from how airlines have successfully dealt with air turbulence.
Fear of Flying
Although airline travel has become accessible to millions of people, the fear of flying remains common. Some people are so afraid of flying that they will drive to their destination rather than fly, even though driving is statistically more dangerous. When asked to assess the risk they faced during a flight, most passengers focus on the amount of turbulence encountered.
This binary relationship between turbulence and risk persists in the minds of many travellers, regardless of the facts. Yet we know from careful study that, although turbulence is common, it rarely leads to nor is the primary cause of air tragedies. Instead, human error, mostly by pilots, is the leading cause of aviation accidents. For example, confusion on the flight deck, not severe weather, was recently revealed to be the primary cause of the Air France 447 tragedy over the Atlantic in June 2009.
Imagine if decades ago, the airlines and FAA had fallen into this same line of thinking and concluded that turbulence was the leading cause of accidents. No doubt air travel would be much less safe. Pilots would be trained to focus on avoiding turbulence, with absurd results such as flights to Paris landing in Omaha. The critical role played by human error in most accidents would remain undetected, leaving passengers subject to arbitrary decisions and unreasonable risk, all in the name of turbulence reduction.
In similar fashion, many investors are preoccupied with volatility and equate it with risk. Rather than address their anxiety directly, investors trade off equity exposure for the equivalent of the smooth ride to Omaha. By choosing to equate volatility with risk, they lose perspective and thus ignore the resulting large underperformance opportunity costs embedded in client portfolios.
Unlike the airlines, our industry has chosen to mislead ourselves and our clients with the false promise that volatility can be engineered out of portfolios at little or no cost. Modern portfolio theory serves as the elegant, yet flawed notion that the proper combination of low-correlation assets will allow clients to arrive at their destination without a bumpy ride. Since the autopilot failed in 2008, many advisers have turned to tactical market timing only to miss substantial gains during the recovery.
With these lessons from the airline industry in mind, let's see how keeping volatility in proper perspective allows us to build optimal investment portfolios.
The Relative Unimportance of Volatility in Long-Term Portfolios
"It is only the price on the final day that counts." -Warren Buffett
The financial goal for an investor should be a wealth-maximizing portfolio. To reach this goal, both expected returns and risk must be considered. Portfolio risk is measured not as volatility, but as the chance of underperformance resulting from building a sub-optimal portfolio. In the case of a short-term horizon, volatility plays a major role in determining portfolio risk as it increases the chance of underperformance. For short periods, the greater the volatility, the greater the risk.
However, as the investment horizon lengthens, the importance of volatility diminishes as a consequence of time diversification. In parallel, expected returns become the primary drivers of underperformance risk. For example, investing in a lower expected return asset class increases the chance of underperformance, while investing in a higher expected return asset class decreases the chance of underperformance.
To better understand this, consider the recent 60-year performance of stocks (S&P 500), T-bonds, and T-bills presented in Figure 1.
Figure 1 clearly illustrates the risk, as measured by underperformance, of investing in lower expected return markets. For example, by investing in supposedly "risk-free" T-bills, one has given up $4.5 million in wealth for the initial $10,000 investment. This seems an extreme price to pay in order to avoid short-term stock market volatility. This is like landing in Omaha rather than enduring the bumps to Paris. Investing in lower expected return asset classes, such as T-bonds or T-bills, impairs long-term performance even as short-term volatility is reduced.
The question then becomes a matter of timeframe. Advisers should take care to segregate short-term liquidity needs from long-term investment decisions. Mixing the two inevitably leads clients back to their fear of volatility, dooming the portfolio to underperform. Industry emphasis on short-term (1-, 3- and 5-year) performance data complicates matters, as investors end up focusing on short-term volatility even in long-term portfolios. People pay attention to what gets measured regardless of whether it is important.
And long-term is the most common horizon faced by investors. Goals such as saving for college when kids are young, saving for retirement, or just trying to build wealth all imply long-term investment horizons. Even recently retired individuals must plan for a life expectancy measured in decades, and thus face a long-term horizon as well. (See Nick Murray's "On Panic, Faith, and the Determined Primitive" in the November 2010 issue of Financial Advisor Magazine for an excellent treatment of this latter issue.)
To appreciate how irrelevant volatility should be when building a long-term portfolio, consider the following three possible outcomes for a $10,000 investment lasting 60 years (see Figure 1): T-bills become worth $160,000, T-bonds almost $390,000, and stocks reach $4.7 million. Which to choose? Obviously the $4.7 million stock investment, correct? But many investors will fixate on the short-term unpredictability of equity returns evident in Figure 1. As a result, they invest in fixed income securities and end up with the proverbial "smooth ride to Omaha." Given the volatility of stocks, how many of your clients would choose to earn the $4.7 million? This fear leads to the large opportunity cost of not keeping volatility in perspective.
There is no guarantee that the future will look like the past 60 years; in fact, you can count on it being much different. The point is not the specific amount of wealth being generated, but the role of expected returns required to generate that wealth. If you believe that stocks will continue to outperform Treasuries and provide the highest expected return over the long term, then you must prevail over client anxiety and keep them airborne to their final destination. Better to adhere to Buffett's admonition that it is only the price on the final day that counts.
Notice how the stock portfolio gains "altitude" over time. Given the return advantage of stocks (in this example 5.5 percent annually over T-bonds and 7.5 percent over T-bills) the risk of stock market underperformance decreases as the time horizon lengthens. In the same way, pilots equate altitude with safety, as it provides more time and distance to correct for unforeseen turbulence. Long-term expected returns are the most important drivers of both wealth and risk, and short-term volatility shrinks to insignificance.
Just to be clear, we are not asserting that one should invest in the stock market simply because it has done well in the past. Instead we argue that building long-term portfolios should be based on long-term asset class expected returns. The highest expected return asset class should dominate the portfolio. If you do otherwise, then you are building a sub-optimal portfolio. This is like driving rather than flying in order to avoid turbulence, which means you now face a greater risk of deadly accidents and increased costs You also have dramatically shrunk the number of destinations to which you can travel. Lacking the long-term expected return perspective is costly.
Besides permanently reducing exposure to volatile markets, other methods for dealing with volatility include market timing, put options, collared positions, and short-selling. Yet the evidence is clear that professionals have little demonstrated market timing skill. Volatility reduction instruments, such as put options and collars, are expensive to implement, which means investors incur both higher transactions costs as well as lower returns. Short-selling, for the purposes of volatility reduction, is an expensive solution as the market goes up during 60 percent of months. The cost of short-selling has been particularly high over the prior two years as the stock market has generated a 100 percent return.
Many advisers look to style boxes as a way to reduce volatility. But the problem with this approach is that style indices are highly correlated and so provide few diversification benefits. But more important is whether investing across style boxes increases or reduces expected returns. This is the relevant issue rather than diversification potential.
Currently there is strong interest in so-called alternative investments. The goal is to find uncorrelated offerings that can be added to the investor's portfolio in order to reduce volatility. But if the alternatives do not also provide higher expected returns, then a sub-optimal portfolio is planned for by definition. Expanding the conclusion from above, long-term expected returns are the most important drivers of wealth and risk, and short-term volatility, correlation, and diversification shrink to insignificance in the long run.
So What to Do?
Keeping volatility in perspective is something investors and their advisers must do in order to build long-term optimal portfolios. Many have attempted other approaches designed to make the stock market suit their temperament, but successful investors accept volatility as an inseparable reality of owning stocks and adjust their behavior to fit the market, not the other way around. Here are a few practical suggestions to help your clients gain perspective:
- Work with clients to get them to accept and acknowledge their fears. Help them learn not to overreact by setting expectations and educating them.
- Reinforce client confidence with an agreed-upon disciplined and consistent long-term investment process. You are the pilot. You have their best interests at heart and your decisions flow from a seasoned, carefully researched methodology. Remind them that by making costly short-term mistakes, their long-term goals are at stake.
- Clients have both short- and long-term investment horizons. A common example involves clients entering retirement with income requirements today, but growth objectives for capital required many years hence. It is important to clearly segregate assets into separate portfolios to avoid emotionally driven decisions on the basis of current events.
- If your client faces a long-term horizon, don't set short-term performance targets. Such a step diverts attention to immediate events, which leads to an unwanted focus on volatility. Confusing long-term strategies with short-term tactics will put volatility at the center of the investment process and derail long-term objectives.
- In the same regard, standard deviation as a measure of volatility should play a much diminished role. The significance of this metric is overstated, often featured for each position held in the portfolio as well as in aggregate.
- As expected returns increase, the risk of underperformance decreases. This contradicts the widely held belief that there is a positive risk-return relationship. But as previously discussed, the higher the expected return, the lower the risk of underperformance.
The truth is that we live in a random world full of random events to which market participants react randomly. To persevere, investors must select investments that meet their standards and then have the conviction to ride through the turbulence, holding positions that continue to meet their criteria. Try thinking of yourself as the pilot focused on your instruments and flight plan, not the bumpy ride. See you in Paris!