Why Volatility Matters

How should you invest if you want to improve the odds of meeting your financial goals?

In the previous article (link to article ), we reviewed how diversification can improve the efficiency of your investment portfolio. If you have two assets with similar return and risk characteristics and limited correlation, you can build a portfolio that has similar expected return as a 1-asset portfolio but with less volatility risk.

The image below is a representation of this phenomenon.

In this article, we are going to take a look at why that matters.

Let’s start all the way at the beginning and consider our reason for investing in the first place.

Is our goal to invest in such a way that we increase our odds of becoming as wealthy as possible?

Or is our goal to invest in such a way that we increase our odds of meeting or exceeding our financial goals?

If your answer is the former, you might as well stop reading. The rest of this article will be a big disappointment.

My opinion is that everyone should be investing in such a way that increases their odds of meeting their financial goals.

Now that we have laid that groundwork, let’s consider the title image (also below).

This image represents the range of portfolio outcomes of the 1 and 2-asset portfolios that were discussed in the previous article.  For the sake of discussion, let’s assume that the time represented on the x-axis of the graph is a 10-year period and that this matches your investment time horizon.

The dashed blue line of the graph represents the idea that each of the portfolios have similar expected median outcomes. The 2-asset portfolio would actually have a higher expected median outcome over a 10-year period due to less volatility decay than the 1-asset portfolio, but we will assume similar median outcomes for this conversation.

The main takeaway here is that the 1-asset portfolio, which has a higher annualized volatility, has a wider range of final outcome than the 2-asset portfolio.

This makes complete sense given the nature of volatility. A portfolio with a larger range of outcome in any one year (higher standard deviation) will have a larger range of outcome over a multi-year period.

To drive this point home, here is an equation for the relationship between annualized volatility and the standard deviation of total return over a multi-year period:

While the upside potential of the 1-asset portfolio might seem enticing, we need to revisit our goal of investing in the first place.

If you are still reading, it means that you agreed that your goal of investing is not to increase your odds of becoming as wealthy as possible. Therefore, this upside potential should not matter much to you.

If you are investing in a way to increase the odds of meeting your financial goals, the downside potential is what should matter most.

Looking back at our title image, let’s assume that the lower lines of the two portfolios represent 2 standard deviation events below the median outcome.

For the 1-asset portfolio, a 2 standard deviation event to the downside might mean that you end the 10-year period with the same amount of money you had at the beginning.

For the 2-asset portfolio, a 2 standard deviation event below the median outcome would not be as bad as the 1-asset portfolio because of the lower volatility of the portfolio. This improvement of your worst-case scenario might mean the difference between meeting or not meeting your financial goal.

Making big bets on a single stock or asset might seem like the path to riches, but broader diversification might be the most prudent approach in order to meet financial goals.

If you would like to dive deeper into this concept of lowering volatility to improve financial plan success, I would encourage you to watch the video linked below titled, “Why Should I Care About Volatility?”

In the video, I assign return and volatility numbers to 1 and 2-asset portfolios and then run Monte Carlo simulations using those numbers to determine the odds of success for meeting financial goals.