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Why volatility matters

Markets have certainly been a bit on edge lately. After an abnormally calm 2017, stocks are reminding investors, on an almost daily basis, of the riskiness of investing in the equity market. In 2017 there were a total of 8 days when the stock market went up or down by more than 1%. So far in 2018 there have been 27 daily moves of greater than 1%. The S&P 500 had no 2% moves last year but already has 8 this year. While the headlines certainly have something to do with these moves, we believe that program trading based on computer algorithms is the bigger culprit. We base this on the huge spikes in trading volume over short intraday periods in the ETF (exchange traded fund) market. Generally, these programs try to take advantage of short–term momentum and flood the market with trades when they “calculate” a trend developing.

Volatility harms an investor in two ways: emotionally and mathematically. The emotional impact is straightforward and easily understandable. Fear often leads to investors withdrawing money from the stock market even though market fundamentals are appealing. This often leads to not participating in the longer-term appreciation of the market. The mathematical impact is far harder to recognize and understand. An investor’s ending wealth is based upon two components, return and volatility. We apologize for the following 2 sentences in advance, please please please don’t hit delete! Compounding of investment returns is based upon the geometric mean, not the arithmetic mean. A general principle of the geometric mean is that all things being equal, volatility reduces ending wealth. Hopefully you’re still with us. Here’s a simple example of two investors to illustrate. Each investor averages a 10% return each year for 10 years. Investor A gets exactly 10% each year while investor B averages 10% by going up 30% and then down 10% the next year. Here’s the impact on a $100,000 investment.

Even though both investors averaged 10%, Investor A ended up with $40,000 more than Investor B. This is the mathematical reason behind why we focus so much time minimizing the volatility of your portfolios. Volatility creates inefficient compounding and erodes your wealth. Creating the optimal asset mix to minimize your volatility likely isn’t the most interesting topic to you, but we hope this helps you understand the importance of proper asset allocation.

The GreenPort Team

P.S. Our models are also telling us it’s going to be 75 and sunny. Unfortunately, the model doesn’t forecast when. :-)

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