Portfolio Volatility: Friend or Foe?

Transcription

1 Volatility: Friend or Foe? The choice is yours if your financial goals are well defined. KEY TAKEAWAYS Set clear goals for your financial plan. Understand the impact different expected investment returns can have on your outcomes. Don t take the results at face value. Use a Monte Carlo analysis to build random scenario outcomes into your plan. Understand that risk can be good and bad for your portfoio. Most investors, and even many advisors, interpret the word "volatility" as a bad thing when it comes to making investment decisions. Often, that is a wise interpretation. investors where to invest your hard-earned dollars. Rather, it is to help you assess the need or opportunity to inject or remove volatility from your portfolio. However, what most investors may not recognize is that they will need, or even require, volatility in their portfolio if they hope to achieve their financial goals. Setting financial goals is at the heart of what Covenant does for client families and is something we explore through our Lifestyle. Legacy. Philanthropy. planning process. First, let s get past the technical jargon that often seems unavoidable in the planning and investing world. Volatility in the investment arena is a term used to measure the fluctuation, or variability, of returns in a portfolio, asset class or individual security. Investment professionals often use the statistical concept of standard deviation to measure volatility. In straightforward terms, volatility measures the movement of portfolio, The objective of this article is not to instruct 216 COVENANT 1

2 asset class, or security returns (up and down) over a period of time. If there is any certainty in investing, it is that sometimes returns go up and sometimes they go down, and never is this pattern identically repeated. This erratic pattern is measured by volatility. To illustrate the concept of volatility, we have created two scenarios. Both scenarios are based on identical facts; the only difference is how the portfolios are invested. The first scenario, call it "Capital Appreciation," has a higher expected return and a higher expected level of volatility. The second scenario, call it "," has a lower expected return along with a lower expected level of volatility. The two pie charts to the right provide a high-level overview of how these two portfolios might be invested. As you will notice, the Capital Appreciation scenario has a significantly higher investment in equities (stocks), and the scenario has a significantly higher investment in fixed income (bonds). Both of these portfolio mixes can be appropriate for investors. However, if proper Lifestyle. Legacy. Philanthropy. goals are not well defined, then choosing the proper portfolio becomes a challenge. Said another way, sometimes you want the highest expected return and sometimes you may not. It s all about the impact the volatility of returns creates overlaid with your specific financial objectives that should drive portfolio design. Capital Appreciation Model (7.22% blended rate) Cash (1.%) (21.%) Taxable Bonds (1.%) Equities (68.%) Model (4.47% blended rate) Cash (1.%) Equities (2.%) (23.%) Taxable Bonds (56.%) What You See Is Not Always What You Get Next, let s explore these two scenarios assuming that the investor receives the expected blended-rate returns shown above from each of these portfolios. In the Cash Flow Capital Appreciation analysis on the next page, you notice that the Smyth family earns the expected 7.22% 216 COVENANT return in each year of the analysis and accumulates over $26,8, of portfolio assets by 252 (as illustrated at the bottom of the Assets column on the far right). This looks like a successful strategy for this family, and it may very well turn out to be just that. 2

3 Cash Flow - Capital Appreciation* Base Facts (All Years) The Cash Flow report illustrates your income, savings, expenses and resulting net cash flow on an annual basis. Year Age 56/55 57/56 58/57 59/58 6/59 61/6 62/61 63/62 64/63 65/64 66/65 67/66 68/67 69/68 7/69 71/7 72/71 73/72 74/73 75/74 76/75 77/76 78/77 79/78 8/79 81/8 82/81 83/82 84/83 85/84 86/85 87/86 88/87 89/88 9/89 91/9 Flows $549,5 549,922 55,353 55, , ,71 529,5 529,5 529,5 44,864 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 26,592 Investment $ Distributions $ 17, , ,82 29, ,47 24, , , , ,52 331,57 352, ,69 398,246 42, ,81 467, , , , ,789 $91,2 91,2 91,2 91,2 91,2 91,2 91,2 91,2 91,2 4,315,911 1,16,654 $64,7 642, ,91 62,7 62,7 62,7 4,36,775 75,74 75,74 75,74 75,74 246, , ,56 285,356 3, ,29 331, , , ,756 46, ,932 45, ,95 496, , , ,29 593,437 1,776, ,381 In the Cash Flow scenario on the next page, the same family the Smyths chose to invest in a portfolio with an expected annual return of 4.47%, and they achieved just that through 252. However, their portfolio only grew to just over $1,, during that same time frame. At first glance, the obvious question seems to be: Why would you ever invest using the scenario? Unfortunately, this is often where many investors stop in the planning process. At Covenant, we believe this is really just the first phase of the analysis, and we know much deeper study must be undertaken in order to get to the most appropriate answer for each individual investor. 216 COVENANT Expenses $596,2 595,2 595,2 594,7 595,39 61, ,294 62,437 68,781 1,61, , , , , , ,734 37,61 317, , , ,8 364, , ,474 46,6 42, ,932 45, ,95 496, , , ,29 593, , ,132 Savings $44,5 45,922 46,353 47,293 48,242 49,71 28, 28,5 29,5 Outflows $64,7 643, ,2 624,294 63, ,281 1,61, , , , , , ,734 37,61 317, , , ,8 364, , ,474 46,6 42, ,932 45, ,95 496, , , ,29 593, , ,132 Net Cash Flow $ (1,19) (8,119) (3,594) (1,237) (17,581) 3,299,139 (157,195) (156,675) (162,43) (167,575) (173,258) (5,269) (48,5) (45,99) (43,18) (39,794) (36,51) (32,521) (27,96) (23,65) (19,844) (13,933) 1,16,654 (3,751) Growth $14, ,48 128, ,25 156, ,79 188,316 24,46 221,84 552,81 526, ,37 581, , , , ,27 745, , ,971 86,2 92,46 946, ,638 1,41,41 1,92,67 1,146,482 1,23,72 1,263,474 1,325,832 1,391,64 1,459,341 1,53,822 1,65,681 1,684,19 1,788,594 Activity $54,5 55,472 55,93 56,843 57,792 59,251 36,25 36,75 37,75 (17,761) (182,857) (195,82) (29,652) (224,47) (24,325) (256,272) (274,113) (292,165) (311,52) (331,57) (352,228) (374,69) (398,246) (42,812) (443,81) (467,662) (492,325) (517,733) (658,22) (536,789) Assets $1,89,215 1,981,95 2,165,754 2,364,622 2,577,621 2,8,462 3,21,434 3,252,47 3,494,38 7,345,6 7,715,168 8,111,863 8,531,756 8,976,354 9,447,285 9,94,366 1,384,36 1,887,819 11,416,92 11,972,627 12,556,253 13,169,56 13,813,661 14,49,529 15,21,43 15,948,66 16,742,914 17,572,25 18,437,253 19,342,273 2,289,527 21,281,26 22,319,73 23,47,651 25,594,194 26,842,248 Digging Deeper: Getting to the Most Appropriate Investment Decision The two cash flow analyses provide a good starting point in a financial plan. They help investors better understand the income, expense, tax and other cash ins and outs of their financial life. These flows also include ins and outs from the portfolio, including dividends, interest, capital gains and losses, and price appreciation. However, there is no portfolio return volatility in these two analyses, and that is where investors can go wrong. You simply cannot achieve the same expected return each and every year over any meaningful time horizon unless you sit in cash. Even then, volatile inflation will disrupt the outcomes. 3

4 Cash Flow - * Base Facts (All Years) The Cash Flow report illustrates your income, savings, expenses and resulting net cash flow on an annual basis. Year Age 56/55 57/56 58/57 59/58 6/59 61/6 62/61 63/62 64/63 65/64 66/65 67/66 68/67 69/68 7/69 71/7 72/71 73/72 74/73 75/74 76/75 77/76 78/77 79/78 8/79 81/8 82/81 83/82 84/83 85/84 86/85 87/86 88/87 89/88 9/89 91/9 Flows $549,5 549,922 55,353 55, , ,71 529,5 529,5 529,5 44,864 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 75,74 26,592 Investment $ Distributions $ 119, , ,65 135,123 14, , , ,57 164,47 17, , , , ,384 2,828 26,11 211, , ,3 224,49 216,593 $91,2 91,2 91,2 91,2 91,2 91,2 91,2 91,2 91,2 4,315,911 1,16,654 $64,7 642, ,91 62,7 62,7 62,7 4,36,775 75,74 75,74 75,74 75,74 195,37 2,93 25,354 21, , , , ,211 24, ,27 252,9 258, , ,88 276, , , , ,77 1,46,47 243,185 Expenses $596,2 595,2 595,2 594,7 594,775 6,72 595,629 61,696 67,962 1,51,73 224, ,67 234,782 24,49 245, , , , ,319 34,18 312,82 32, ,71 337, , ,453 35, , ,53 379, , ,16 49,35 419,912 43,369 44,855 Savings $44,5 45,922 46,353 47,293 48,242 49,71 28, 28,5 29,5 Outflows $64,7 643,17 65, ,629 63, ,462 1,51,73 224, ,67 234,782 24,49 245, , , , ,319 34,18 312,82 32, ,71 337, , ,453 35, , ,53 379, , ,16 49,35 419,912 43,369 44,855 Net Cash Flow $ (575) (7,52) (2,929) (9,496) (16,762) 3,39,45 (155,147) (153,966) (159,78) (164,345) (169,757) (78,279) (81,521) (83,491) (85,492) (87,52) (89,653) (92,396) (94,86) (97,761) (1,897) (96,363) (92,583) (95,35) (98,415) (12,586) (17,224) (112,188) (117,511) (123,25) 1,3,38 (197,67) Growth $65,996 71,334 76,972 82,881 89,98 95,631 12,524 18, , , , ,193 31,471 37,8 314,174 32, ,52 331, , , , , ,432 36, , , ,84 378, , , , , ,31 399,55 41, ,477 Activity $54,5 55,472 55,93 56,843 57,792 59,251 36,25 36,75 37,75 (119,333) (124,389) (129,65) (135,123) (14,812) (146,725) (152,275) (158,57) (164,47) (17,323) (176,386) (182,588) (188,925) (195,384) (2,828) (26,11) (211,124) (216,135) (221,3) (342,414) (216,593) Assets $1,782,685 1,99,491 2,42,366 2,182,9 2,328,45 2,475,767 2,611,612 2,747,563 2,883,715 6,57,647 6,641,732 6,782,959 6,925,352 7,68,87 7,213,224 7,336,23 7,456,345 7,574,585 7,69,593 7,84,48 7,914,469 8,21,49 8,124,555 8,223,382 8,317,526 8,414,33 8,512,936 8,66,826 8,695,339 8,778,14 8,854,773 8,924,698 8,987,362 9,42,29 1,131,284 1,142,498 So how can we get our arms around the impact volatility has on an investor s financial life? Sorry, but here comes technical term number two: Monte Carlo analysis. Monte Carlo analysis runs multiple simulations of a financial plan against various future market conditions. Introducing random investment volatility to the analysis produces a range of values that demonstrates how changing investment markets may impact your future plans. summarize, the expected outcomes for this plan lie somewhere between $176,42 on the low end and $48,5,897 on the high end. Take note that these potential outcomes are very different from the cash flow analyses above, which use constant annual returns. Pay particular attention to the median return here of just over $11,7, versus the $26,8, in the cash flow analysis. Volatility makes a difference, and investor expectations should be adjusted accordingly. The Monte Carlo Summary Capital Appreciation chart on the next page introduces volatility to a financial plan and allows an investor to understand the probability of success of the plan. There is a good bit of data below, but if you focus on the table with the blue header, you will see that the range of possible investment outcomes for the Capital Appreciation portfolio is quite wide. To The gray box immediately below the table indicates that this plan is successful 98% of the time success being defined as a result greater than zero in this case. We believe that most investors would judge this plan to be one they would like. They have good upside opportunity, and they are not likely to run out of money in their lifetimes. Our question would be: Can it be better? 216 COVENANT 4

5 Monte Carlo Summary - Capital Appreciation* Monte Carlo Summary - * Base Facts Base Facts The table below shows an upside case, the median case and a downside case from the 1, trials. The table below shows an upside case, the median case and a downside case from the 1, trials. Case Case Percentile Assets Upside (Outperform) 97.5 $14,799,977 $48,5,897 Median (Moderate) 5. $7,47, $11,73,7 Downside (Underperform) 2.5 $2,861, $176,42 Percentile Assets Upside (Outperform) 97.5 Median (Moderate) Downside (Underperform) This Monte Carlo simulation is successful in 98% of the trials. This Monte Carlo simulation is successful in 1% of the trials. Asset Comparison Asset Comparison The chart below illustrates an upside case (97.5 percentile), the median case (5 percentile) and a downside case (2.5 percentile) from the 1, trials. The chart below illustrates an upside case (97.5 percentile), the median case (5 percentile) and a downside case (2.5 percentile) from the 1, trials. 14 Assets ($1s) Assets ($1s) Downside Median Upside The answer to that question is a strong maybe. This is beginning to sound like a broken record, but the answer really depends on investors' financial goals and their appetite for volatility, or risk. The Monte Carlo Summary for the analysis follows and has dramatically different results. The range of outcomes from almost $2,9, on the low end to just under $14,8, on the high end, with a median result of about $7,5,, is much narrower than the Capital Appreciation analysis. You will also note that the investor achieves success in all 1, outcomes in this simulation. The investor implementing this strategy has given up a lot of opportunity for portfolio growth but has also limited downside results. This tends to be the sleep better at night strategy. 216 COVENANT Downside Median Upside Unfortunately, we still have not answered the question: Is this the better portfolio? Putting it All Together: The Right Amount of Volatility to Meet Your Financial Goals Once we go through these exercises to test for potential investment and financial plan outcomes, we can then lead investors through our Lifestyle. Legacy. Philanthropy. financial planning process to direct them toward the most appropriate portfolio for their specific situation. What usually results is a better understanding of why the portfolio with the potential for the highest returns may not be the one they should choose. 5

6 For example, most investor lifestyle goals are such that they do not have a lot of wiggle room built in. Investors need to be very confident that the portfolio is going to last, and that it will allow them to live the life they have earned. They really do want to sleep well at night knowing that they will achieve portfolio growth over time and will not have to be overly concerned about the major ups and downs (volatility) of the markets. For this goal, something more like the scenario could be more appropriate. afford the swings in return patterns, or are reaching to attain a goal they otherwise could not reach without the higher returns, the Capital Appreciation scenario is absolutely appropriate. For example, if a husband and wife have set a goal of leaving $5,, to charity as well as $5,, each to their two children, the scenario simply would not work since none of the scenarios creates this much capital. They would have to invest differently. s may have an objective that they want to leave at least $2,, toward a philanthropic legacy. If they really want to be certain of meeting this goal, these investors would also lean toward the scenario, as the downside results are much more certain than the Capital Appreciation scenario. That is, investors can be more confident the dollars will be there to fund the legacy. As you can see, how to invest is truly driven by investor goals and objectives. In reality, investors have multiple goals lifestyle, legacy and philanthropy so the most appropriate investments must take into account all objectives. The process doesn t stop there, however. Investing and financial planning are ongoing and should be monitored closely. Everyone s financial life tends to change; therefore, the plan and the portfolio may need to change with them. On the other hand, are there instances when the Capital Appreciation scenario is more appropriate? Of course there are! Many investors have an income stream from a retirement plan or other source that more than provides for their lifestyle needs. For investors like these who can If you have not gone through this type of analysis in designing your financial plan and portfolio, please feel free to reach out to Covenant. We would love to engage you in the process. *The Cash Flow and Monte Carlo analysis were generated using emoney emx financial planning software. COVENANTMFO.COM 216 COVENANT Covenant is an SEC registered investment advisor. 6