The goal of financial planners is to help clients

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1 Volatility and Targeted Portfolio Returns Travis L. Jones, a Steve P. Fraser, b and J. Howard Finch c Financial planners face a consistent challenge to help clients understand the trade-off between risk and return. Most clients relate to the idea of a targeted level of expected return to achieve specific wealth goals but with limited understanding of the required risk. Extended investment horizons require client discipline when market volatility appears to be enhancing the possibility of loss of wealth. The purpose of this article is to illustrate that bearing the risk associated with market volatility can reward clients with the achievement of targeted portfolio returns, even during times of great financial and economic uncertainty. Data from 1994 to 2013 is used to create hypothetical portfolios consisting of stock and bond allocations designed to target specific client return objectives. Graphical charts illustrate the resulting annual volatility associated with multiyear investment horizons. Financial planners can use these examples to better communicate the historical volatility associated with portfolios constructed to deliver target levels of return to clients. Keywords: asset allocation, financial planning, portfolio volatility, risk tolerance The goal of financial planners is to help clients achieve desired targets of wealth accumulation and preservation. Doing so effectively over extended time horizons requires planners to manage the risk-reward trade-offs inherent in volatile asset markets. If markets are relatively efficient, then efforts devoted to predicting future asset values and volatility are largely futile and costly. However, advisors may use past volatility to illustrate to clients the relative amount of expected volatility associated with specific portfolios or targeted levels of required return. The purpose of this article is to highlight the inherent trade-offs associated with targeting specific levels of portfolio returns. Targeting a specific return may lead to larger volatility than clients expect, increasing the temptation to abandon carefully constructed portfolios during times of high market volatility. The discussion of risk and return concepts with clients can be fraught with difficulty. Although most clients intuitively understand the concept of return, a discussion of risk can be more troublesome. One of the major impediments contributing to client confusion regarding portfolio risk is terminology. Malkiel (2012) describes a critical planning step that involves clarifying one s attitude toward risk and one s capacity toward risk. Planners necessarily form portfolios based on a client s capacity for risk. A client s attitude toward risk leads to another widely used term risk tolerance, which suggests an attempt to determine how much risk an investor might be willing to assume. Bailey and Kinerson (2005) examine the concept risk tolerance and its effect on investment decisions, noting that an individual s risk tolerance predicts investment decision behavior. Yao, Gutter, and Hanna (2005) look at the effects of ethnicity and race on risk tolerance. Mooreland (2014) discusses this concept of a client s qualitative attitude toward risk, as well as the concept of loss aversion. Perhaps a more prevalent term used is risk aversion. Risk aversion examines one s attitude toward risk from the viewpoint that risk is something to be avoided. Hanna and Lindamood (2004) examine risk aversion by using graphical presentations to better clarify the change in income of respondents to questions used to measure risk aversion. Grable and Rabbani (2014) introduce the term risk portrait to capture a holistic representation, which encompasses both attitude and capacity. Given these and other financial terms, it is no wonder planners and clients do not always communicate clearly. The use a Professor, Finance, Lutgert College of Business, Florida Gulf Coast University, FGCU Blvd. South, Ft. Myers, FL tljones@fgcu.edu b Associate Professor, Finance, Lutgert College of Business, Florida Gulf Coast University, FGCU Blvd. South, Ft. Myers, FL sfraser@fgcu.edu c Professor, Finance, Brock School of Business, Samford University, 800 Lakeshore Drive, Birmingham, AL hfinch@samford.edu 122 Journal of Financial Counseling and Planning, Volume 27, Number 1, 2016, Association for Financial Counseling and Planning Education

2 of graphical illustrations of volatility over time may provide clients the opportunity (and possibly comfort) to see that, despite annual volatility in yearly returns, a long-term average return target is still an achievable outcome. This study adds to the financial planning literature by using graphical depictions of the changing nature of volatility across multiyear investment horizons to help clients comprehend historical volatility associated with targeted portfolio returns. Background Financial planners generally begin their work for clients by identifying specific financial goals to be achieved. Part of this process is quantifying expected returns needed to achieve the goals and analyzing the relative risk (attitude/ capacity/tolerance/aversion/portrait) of clients so that model portfolios may be constructed. For this article, the term risk profile is defined as an assessment and description of a client s overall level of risk. Although target required returns derive directly from the future amounts needed for goal attainment, no uniform approach exists to quantify client risk. Many planners use some type of survey or questionnaire to gain insight into what might be the appropriate level of risk for the client (see Grable & Lytton, 1999, as one excellent example). More recently, Pan and Statman (2012) suggest a more comprehensive questionnaire that includes behavioral attributes such as overconfidence. Griesdorn and Smith (2014) examine the implications of how information is depicted in such surveys. The authors find clients preferences may change depending on whether the question includes a visual representation of probabilities. Other avenues and measures in the examination and depiction of client and portfolio risk include Milevsky and Robinson s (2005) probability of ruin. They define risk as outliving your resources and portray risk as a function of spending, heath factors (including age), and the asset allocation decision. Grable and Rabbani (2014) consider risk attitudes with nonfinancial risk factors such as those associated with health or occupation. Gilliam, Goetz, and Hampton (2008) note the differing risk tolerances among spouses. Guillemette and Finke (2014) examine whether fluctuations in equity returns influence average risk tolerance scores. They find a strong correlation between monthly risk tolerance scores and the Standard & Poor s (S&P) 500. The authors conclude this result may explain why investors tend to shift portfolio allocations during down markets. Bronson, Scanlan, and Squires (2007) discuss the subjective nature of determining an investor s willingness to take risk and suggest the determination of an investor s willingness to take risk is an imprecise science. Many investors may need to experience losses before undertaking a meaningful dialogue of their risk profile. The asset allocation decision is a planner s ultimate tool to satisfy clients objectives. Ibbotson and Kaplan (2000) suggest that more than 90% of the variation of a portfolio s return over time can be explained by asset allocation, which has much greater influence than individual security selection. Even with an appropriate portfolio, a planner still needs to communicate the characteristics of the portfolio and encourage the client to stay invested during periods of market extremes. It is common to measure the risk of a portfolio by examining the volatility of returns, specifically standard deviation. Clients often struggle with interpreting standard deviation as the statistical measure of the amount of risk exposure inherent in a targeted portfolio return objective. A common client question often falls along the lines of how much risk would I have to take to earn an average of 7% per year? The analysis that follows is designed to assist financial planners with having effective risk-return discussions with their clients. Illustrating the Risk-Return Trade-Off Across Multiyear Investment Horizons Planners need the ability to illustrate the volatility inherent in a targeted portfolio return. To do so, we construct hypothetical two-asset portfolios consisting of equities (proxied by ETF SPY) and bonds (proxied by ETF AGG), including dividends and interest, respectively. Data from the 10-year period 2004 to 2013 is examined to determine the weights of asset classes required within the portfolios to obtain targeted returns, with a specific focus on the associated risk as measured by the portfolios standard deviation. The time period is one with both high and low returns as well as considerable financial market volatility. To facilitate the illustration of portfolio volatility over time, we first construct an initial portfolio designed to achieve a targeted 7% compound annual return over the time period. Mean variance optimization or similar analysis might be helpful in constructing this initial portfolio. However, in this article, we simply wish to illustrate the range of annual portfolio returns and the standard deviation of the returns for a portfolio constructed at the beginning of 2004 that ex-post would have provided a 7% compounded annual Journal of Financial Counseling and Planning, Volume 27, Number 1,

3 return through the end of Thus, this investor would have formed, in 2004, a portfolio to yield 96.72% (or 7% compounded over 10 years) through In doing this, we want to illustrate the volatility this investor would have experienced, even with perfect foresight. Figure 1 illustrates how this portfolio, initially composed of between 85% 90% equities and 15%-10% debt securities, would have produced the targeted average annual return of 7%. Over a decade that highlights extreme macroeconomic swings in market risk and returns, the portfolio composition required to deliver the targeted average annual return varied little, as depicted in the first two rows of the table below Figure 1. However, the volatility presented as annualized monthly portfolio standard deviation of returns (computed following Bruce & Greene, 2013) fluctuated dramatically across the 10-year holding period. The solid line in the graph captures the changing risk exposure as market conditions evolved across the 10-year period, from stable macroeconomic growth to extreme recession, concluding with a prolonged, historically weak recovery. Nevertheless, despite the seemingly whipsaw effect of market volatility on year-to-year annual returns, the target portfolio growth rate is achieved. Across the entire 10-year holding period, the client s investment objective was realized using a static asset allocation strategy. Planners may use this graph to illustrate two key aspects of the investment planning success. First, annual market volatility is not a cause for panic, nor does it preclude the ultimate achievement of multiyear investment objectives. Second, the amount of annual portfolio rebalancing, if pursued, would be relatively minor from year to year. In this example, we do not rebalance the portfolio annually. The results show the weighing of stocks and bonds after a decade remains remarkably similar to the initial portfolio. The key teaching point for clients is that (sometimes dramatic) volatility is part of the investment process. Investors need not assume that changing markets automatically preclude targeted investment return objectives conceived under previous, less tumultuous conditions. Of course, excess volatility will result in lower compound growth rates. Figure 1. Portfolio allocations and risk. Note. Asset class allocations that result from initial 87.5%/12.5% stock/bond portfolio at the beginning of 2004, which earned a 7% compounded annual growth rate over the decade (left) and associated risk (right). 124 Journal of Financial Counseling and Planning, Volume 27, Number 1, 2016

4 The key is that the initial multiyear target return objective is a compound average, and financial planners may provide value added for clients by constructing efficient portfolios designed to achieve target returns while minimizing the total risk exposure necessary. Clients often tend to have short-term views of the market and portfolio performance. Most financial planners will at some point need to counsel a client against selling out of a position when the market is down. Most clients dislike these encounters with undesired market volatility. In an ideal world, their preference would likely be for a targeted return that is realized each and every year, rather than through a multiyear average. Of course, such a strategy would result in high levels of transactions costs as well as significant tax considerations. To illustrate the undesirability of this objective, we construct a hypothetical portfolio that was rebalanced each year to deliver the targeted 7% annual portfolio return. In lieu of mean variance optimization or similar analysis, the portfolio weights used here are determined by the asset class performance in the previous year. The respective weights in equity and fixed income were allocated with perfect hindsight such that a 7% target return was achieved for that year without any consideration for volatility. This admittedly unrealistic portfolio nevertheless effectively illustrates the volatility required to achieve a 7% return each year over this investment horizon. Figure 2 illustrates this portfolio. The first and most obvious takeaway from Figure 2 is the completely unrealistic asset allocation decisions that would have been required to deliver the 7% annual return each year over the 10-year investment horizon. In 2005, the bond position would had to have been short sold resulting in 185% equity allocation. Five years later in 2010, only 7% equity exposure would have been required to deliver the 7% return target. The transactions costs alone to implement such a strategy would make it costly and unfeasible. Most financial planners and clients have no desire to engage in such drastic annual portfolio rebalancing, and only hindsight provides insights into how a planner could possibly have been successful trying to do so. Perhaps more important for client education is to note that the volatility in returns was actually much higher for this hypothetical portfolio compared to Figure 1. Clearly, attempting to Figure 2. Portfolio allocations and risk. Note. Asset class allocations required to obtain 7% each year over the decade (left) and associated risk (right). Journal of Financial Counseling and Planning, Volume 27, Number 1,

5 achieve a return target each year (as opposed to a compound average annual target return over the holding period) resulted in a much greater amount of volatility. Even though the targeted return was achieved by year s end, the roller coaster required to achieve it would likely cause many an investor to abandon the objective and flee to alternatives perceived to be safer. Illustrating Portfolio Risk and Return Over Multiyear Time Horizons Financial planners thus face the task of helping clients understand that committing to a compound average annual return objective is a winning strategy, despite the fact that volatility will result in fluctuations in yearly realized returns. As the initial portfolio formed at the beginning of 2004 achieved the 7% compound average return target objective, the actual return on the portfolio each year differed greatly. The actual return each year, together with the standard deviation of the monthly returns, is shown in Figure 3. The bars represent one standard deviation below (grayed), or one standard deviation above (solid black), the resultant rate of return earned each year (the point where the bars meet). The annual returns for our beginning-of-year 2004 portfolio (87.5%/12.5%) were positive in 9 of the 10 years. Figure 3 also demonstrates that the portfolio experienced vastly different returns (negative 32% in 2008 and positive 22% in 2009) with similar risk (18% standard deviation). Likewise, the portfolio earned 14% in both 2006 and 2010 with accompanying standard deviations of 5% and 15%, respectively. Financial planners may use this type of graph to illustrate for clients that the risk-reward trade-off can vary greatly from year to year, depending on market conditions. Nevertheless, it is the average annual growth rate over time that will ultimately deliver the targeted wealth objective, which clients and planners agree to upon embarking on the initial portfolio planning and construction. Finally, the results illustrating the variation in risk over time are not unique or defined by the specified 10-year time horizon from 2004 to Figure 4 illustrates the annual volatility, which a static portfolio would have experienced over Figure 3. Portfolio volatility. Note. The bars depict 1/2 one standard deviation of an initial 87.5%/12.5% stock/bond portfolio at the beginning of 2004 that earned a 7% compounded annual growth rate through The midpoint of each bar represents the return of the portfolio in each year. 126 Journal of Financial Counseling and Planning, Volume 27, Number 1, 2016

6 Figure 4. Portfolio volatility. Note. The bars depict 1/2 one standard deviation of an initial 36.4%/63.6% stock/bond portfolio at the beginning of 1994 that earned a 7% compounded annual growth rate through The midpoint of each bar represents the return of the portfolio in each year. the 20-year horizon from 1994 to Mutual fund data was used for the analysis because of limited historical data for the exchange-traded funds (ETFs). Once again, the client would have experienced large variations in annual volatility, yet the targeted 7% compound annual return was achieved. These results also depict another important component of financial planning market timing. In contrast to the 87.5%/12.5% stock/bond portfolio that yielded a 7% compounded annual return from 2004 to 2013, it was a 36.4%/63.6% stock/bond portfolio that yielded the same 7% compounded annual return over the year time period. Contrasting the hypothetical 10-year portfolio with the 20-year portfolio, financial planners may demonstrate to clients that the issue of market timing centers on the initial portfolio composition at the beginning of the investment horizon, rather than annual (or more frequent) adjustments trying to reflect current market conditions. The stark differences in asset allocation in these two examples demonstrate that targeted compound returns (here, 7%) over multiyear horizons may be achieved despite wide swings in market volatility and annual returns. Although most planners would not recommend that clients try to time the market in terms of when to initially invest, timing does indeed matter in terms of initial asset allocation decisions. Financial planners may use this analysis to depict for clients how dramatic variations in annual rates of return on investment should not necessarily result in dramatic portfolio Journal of Financial Counseling and Planning, Volume 27, Number 1,

7 rebalancing exercises. A clearly defined compound annual goal that results in an initial portfolio asset allocation strategy can, in many cases, produce successful targeted multiyear returns despite dramatic swings in annual market volatility. This article was sent to several financial planners (with the Certified Financial Planner and Chartered Financial Analyst designations) who were asked to report their thoughts on the methodology of the article and whether the results would be useful to illustrate volatility to their clients. Overall, respondents felt that their clients tend to struggle with the concept of annual volatility versus volatility over a multiyear investment horizon, with some planners reporting that clients panic and second-guess long-term investment strategies during market downturns. Most planners felt that a chart showing the achievement of long-term goals despite high rates of annual volatility could be a potentially very useful tool. In addition, most of planners felt that the figures used in this article would be effective tools when used in client investment counseling. Conclusion The inherent trade-off between risk and expected return is one which investors often acknowledge conceptually, but, perhaps unwittingly, circumvent in their investment strategies over time. Investors often can assume more or less risk than planned. Guillemette, Finke, and Gilliam (2012) examine the nature of questions on risk tolerance surveys and the extent they explain portfolio allocations. More important for this study, their conclusions imply that planners may choose portfolios with less risk than those they might otherwise recommend. Lower risk portfolios may ultimately provide better long-run performance by enhancing clients willingness to maintain their initial asset allocations during periods of recession. This study adds to the Guillemette et al. (2012) discussion on the importance of staying invested in periods of high volatility. Graphical analysis illustrates the corresponding annual risk exposure required for a portfolio to meet a targeted specific return over a trailing 10-year holding period. The graphs contrast the portfolio volatility required to achieve a targeted 10- and 20-year compounded rate of return in contrast with a single year annual constant target return goal. Taken together, these examples illustrate the unintended consequences of a target return approach to portfolio formation. Data from a recent 10-year period highlight that there are times when a short-term focus might necessitate illogical portfolio allocations. In the more often long-term targeted return approach, portfolios suffer from assuming more (or less) risk than planned. These limitations notwithstanding, walking a client through a version of the illustration presented here may help planners address a client s question of how much risk is required for my portfolio to produce returns needed to achieve targeted future wealth? The goal of financial planners is ultimately to help their clients achieve desired wealth goals of growth and protection. A common hurdle involves trying to communicate the concepts of risk-return trade-offs over long investment horizons. One of greatest challenges planners face is counseling clients during periods of high market volatility to stay the course and remain faithful to the original asset allocation plan rather than engaging in destructive market timing. The graphical methods of depicting portfolio risk and return presented here, using one of the most volatile and challenging decades of financial market instability in recent history, can aid planners in their initial counseling and annual reviews to help their clients weather high volatility to achieve financial success. References Bailey, J. J., & Kinerson, C. (2005). Regret avoidance and risk tolerance. Journal of Financial Counseling and Planning, 16(1), Bruce, B., & Greene, J. (2013). Trading and money management in a student-managed portfolio. San Diego, CA: Academic Press. Bronson, J. W., Scanlan, M. H., & Squires, J. R. (2007). Managing individual investor portfolios. In J. L. Maginn, D. L. Tuttle, J. E. Pinto, & D. W. McLeavey (Eds.), Managing investment portfolios. Hoboken, NJ: Wiley. Gilliam, J. E., Goetz, J. W., & Hampton, V. L. (2008). Spousal differences in financial risk tolerance. Journal of Financial Counseling and Planning, 19(1), Grable, J. E., & Lytton, R. H. (1999). Financial risk tolerance revisited: The development of a risk assessment instrument. Financial Services Review, 8, Grable, J. E., & Rabbani, A. (2014). Risk tolerance across life domains: Evidence from a sample of older adults. Journal of Financial Counseling and Planning, 25(2), Journal of Financial Counseling and Planning, Volume 27, Number 1, 2016

8 Griesdorn, T. S., & Smith, H. L. (2014). Does visually displaying probability outcomes change stock selection? Journal of Personal Finance, 13(1), Guillemette, M., & Finke, M. (2014). Do large swings in equity values change risk tolerance? Journal of Financial Planning, 27(6), Guillemette, M. Finke, M., & Gilliam, J. (2012). Risk tolerance questions to best determine client portfolio allocation preferences. Journal of Financial Planning, 25(5), Hanna, S. D., & Lindamood, S. (2004). An improved measure of risk aversion. Journal of Financial Counseling and Planning, 15(2), Ibbotson, R., & Kaplan, P. (2000). Does asset allocation policy explain 40, 90, or 100 percent of performance? Financial Analysts Journal, 58(1), Malkiel, B. (2012). A random walk down Wall Street. New York, NY: Norton. Milevsky, M. A., & Robinson, C. (2005). A sustainable spending rate without simulation. Financial Analysts Journal, 61(6), Mooreland, J. (2014). Obtain a more accurate assessment of your client s risk profile. Journal of Financial Planning, 27(7), Pan, C. H., & Statman, M. (2012). Questionnaires of risk tolerance, regret, overconfidence, and other investor propensities. Journal of Investment Consulting, 13(1), Yao, R., Gutter, M. S., & Hanna, S. D. (2005). The financial risk tolerance of Blacks, Hispanics, and Whites. Journal of Financial Counseling and Planning, 16(1), Journal of Financial Counseling and Planning, Volume 27, Number 1,