“Time is your friend, impulse is your enemy. Take advantage of compound interest and don’t be captivated by the siren song of the market. “
- Warren Buffett
By far the biggest risk individual investors face is themselves. When stocks are going up, investors can be found chasing returns and concentrating their investments in the fads of the moment. On the other hand, as markets decline, these same investors are likely to find themselves on the sidelines licking their wounds and sitting in cash. Over-enthusiasm during bull markets combined with over-pessimism during bear markets is a recipe for buying high and selling low – and if done often enough, can lead to permanently impairing one’s capital.
An additional risk many investors face but often fail to understand is how variability within portfolios affect long term performance. Over long periods of time, price volatility diminishes the rate at which an investment grows and has a negative impact on portfolio returns. Mathematically, a volatile portfolio can have a large impact on returns due to its effect on compounding.
Thoughtful asset class diversification is important to implement, not only because it mitigates portfolio variability over time, but also viewed from a psychological perspective, where it enables clients to stay invested during the inevitable stock market declines.
Back in December of 2017, the title of our monthly newsletter was "Professional Investors Manage Risk." At the time, I felt it made sense to pass this topic along to readers, as that past year witnessed minimal volatility, which I found unusual and thought could lead to investor complacency. Given this year’s broadly positive results, and the general focus out there on returns at the expense of risk, I thought it made sense to rehash the subject, but this time pass along a short story included in the book, “The Stewardship of Wealth,” by Gregory Curtis, which illustrates the topic in a easier to digest and more whimsical light.
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Variance Drain
Passage taken from “The Stewardship of Wealth,” by Gregory Curtis
Let's take a focused look at the concept of variance drain and the impact it can have on even a well-managed investment portfolio. The following parable, based very loosely on an actual event, is designed to drive home the important point that controlling portfolio volatility not only makes investors more comfortable, but actually grows wealth faster than more volatile portfolios with the same—or even higher—returns.
Dick and Jane and Variance Drain
Dick and Jane are twins. In case you're wondering, the answer is yes, they have a sister, Sally, and a dog named Spot. For many years they lived a cheery middle-class life. Dick would throw a stick and Spot would chase after it.
“Look, Dick, look!” Jane would say. “See Spot run!”
“Run, Spot, run!” said Dick.
All this came to an abrupt end on their twenty-first birthday, however, for on that day they received an inheritance from Weird Uncle Fred. Uncle Fred had immigrated to Switzerland many years ago, and his legacy was, like Fred, weird.
According to the Swiss trust officer, Uncle Fred had left each of them $1 million. However, the money was in trust and neither principal nor interest would be paid out until their thirty-first birthday. (This meant that the money could compound tax-free.)
But there was a further provision. Uncle Fred considered himself to be a great investor, and he wanted Dick and Jane to become great investors, too. Therefore, said the trust officer, a gnome-like gentleman, at the end of 10 years the trustee was to determine who had invested most wisely—that is, who had the most money in his or her account. That person would receive his or her entire inheritance, together with accumulated income and appreciation. The loser would have his or her inheritance tied up for another 10 years.
This provision concentrated Dick's and Jane's minds wonderfully. Dick had gone to Wharton and was a devotee of John Bogle, founder of Vanguard. “You can't control the markets,” Dick was fond of saying, “But you can control your costs.”
Jane had a degree in art history from Vassar and had never heard of John Bogle. She called her lawyer and her accountant, interviewed several firms, and hired an advisor whose name would be very familiar to readers of this book. That advisor designed a complicated portfolio including eight asset classes, anchored by a 15 percent position in core bonds.
Dick rather liked the 15 percent bond allocation, but as for the rest of Jane's portfolio, he laughed softly up his sleeve. Unlike Jane, Dick made only one phone call: to Vanguard. He put 15 percent of his trust in core bonds and 85 percent in an MSCI All Country World Index Fund.
Over the next 10 years, Jane spent many hours meeting with her advisor, poring over her account statements and constantly tweaking her portfolio. She made many tactical moves, as recommended by her advisor. Sometimes her managers disappointed and had to be replaced. Dick, by contrast, looked at his portfolio precisely once each year. If the portfolio was badly out of balance, he rebalanced back to his 85/15 allocation. Otherwise, he played a lot of golf.
Later, at Le Cirque
Ten years later, Dick and Jane and the gnome-like trust officer met for dinner at Le Cirque restaurant in New York. It was a wonderful, if expensive, meal, and as Dick and Jane were polishing off their gingerbread profiteroles, the trust officer got down to business. Opening his account book, the trust officer reported that, astonishingly, both Dick's portfolio and Jane's portfolio had returned, net of fees, precisely 9 percent per year over the 10-year period.
“A dead heat!” Jane exclaimed.
“Then I win!” Dick interjected. “Poor Jane sweated blood over her portfolio for 10 years, making changes at least every quarter. I, meanwhile, invested in an elegantly simple manner. Weird Uncle Fred would certainly declare me the winner.”
“You may recall,” the trust officer said, “That your Uncle Fred's rules stated that the beneficiary with the largest balance in his or her trust account at the end of 10 years would win.” Pausing for effect, he flipped over to the last page of his account book.
“Dick,” he said, “You've done well. Your final account balance is $1,936,412.” Dick smiled modestly. “I'll pick up the check,” he said.
“Jane,” the trust officer said, “You've also done well. Your balance is $2,387,938.”
A mouthful of Chateau Mouton Rothschild exploded out of Dick's mouth. “W-what?” he stammered.
“You did well, Dick,” said the trust officer, “But you forgot one thing: variance drain.”
After the waiter had finished applying cold compresses to Dick's fevered brow, the trust officer continued.
“Dick,” he said, “I see that you have your iPhone with you.”
Dick had in fact been texting his girlfriend for the past few moments. “WON WON WON,” he'd texted. But now, even as the trust officer was speaking, Dick texted, “forgt abov.”
“Indulge me, Dick,” said the trust officer. “Tap on your calculator app and run these numbers. Suppose that a $1 million portfolio appreciated 0 percent in year 1 and declined 0 percent in Year 2. What would the value of the portfolio be?”
Tap, tap, tap went Dick's fingers. “$1 million,” he said.
“Excellent. Now suppose that the portfolio appreciated 20 percent in Year 1 and declined 20 percent in Year 2.”
Tap, tap, tap. “$960,000,” said Dick. “Hmm.”
“Now, just for fun, let's suppose the portfolio appreciated 50 percent in Year 1 and declined 50 percent in Year 2.”
Tap, tap tap. “$750,000,” said Dick. “I'm beginning to get the point.”
“Right,” said the trust officer. “Everything else being equal, the higher the volatility, the lower the final dollars. A simplified formula for calculating variance drain, as your Uncle Fred well knew, is C = R − σ2/2, where R is the mean return and σ is the variance in the return.”
Dick's eyes glazed over, but Jane was riveted. She well remembered her advisor harping on this business of variance drain, constantly reminding her that she needed to keep her portfolio volatility at the absolute minimum consistent with her return objectives.
“While you have your calculator app open,” the trust officer continued, “do this quick calculation for me. Assume a $1 million portfolio that compounds at 9 percent per year at a variance of 19 percent. That happens to be the volatility of your portfolio over that period.”
Tap, tap, tap, went Dick's fingers. Tap, tap, tap, tap, tap.
“$1,936,412,” said Dick. “What a coincidence.”
“And now, assume a $1 million portfolio that compounds at 9 percent per year at a variance of 10 percent. That happens to be the volatility of Jane's portfolio over that period.”
“I don't need to do it,” Dick said. “It's going to come out to $2,387,938.”
“So it is,” said the trust officer. “You can't control the markets, but you can control your costs. More important, you can control your portfolio volatility.”
“I'll get the check,” said Jane.
Dick tapped on his contacts app. “Okay, Jane,” he said, “What's the phone number of that financial advisor you've been using?”
But Jane was gone, having dashed off to the Ferrari dealership. Run, Jane, run!
Variance Drain Scenarios
For investors who may be interested in exploring the phenomenon of variance drain in greater detail, Table 4.1 shows six scenarios illustrating the accumulative impact of portfolio volatility on final wealth. In Scenario 1, the portfolio grows at 10 percent per annum for 10 years with no volatility. (We can safely assume that this is impossible, but so is much of modern portfolio theory.) The terminal wealth of that portfolio is $2,593,742. To contrast an extreme example, consider Scenario 6, where the portfolio grows at 10 percent per annum for 10 years with a volatility of 50 percent. In this extreme-volatility scenario, the portfolio still boasts a 10 percent annual arithmetic return, but it actually loses money over the 10-year period, resulting in an ending value of only $782,784.
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It is clear to me after listening to Federal Reserve Chairman Jerome Powell’s testimony and Q&A to Congress’s Joint Economic Committee on Wednesday November 13th, that the Fed will do whatever it takes to keep our record economic expansion in the U.S. going for as long as possible. Jay Powell is a rare bird in economic circles and also as a Fed Chair (remember Greenspan?) – as he communicates clearly, effectively and simply answers questions directly. This could have something to do with Powell’s lack of a Ph.D degree in Economics - I’m just sayin…
Anyway, it doesn’t mean Jay Powell won’t stumble along the way, as he clearly displayed his lack of experience during the December 2018 Q&A session surrounding the Fed decision, where he came off nonsensically hawkish, which exacerbated the stock market’s decline into year end. Nevertheless, he appears to be a fast study.
To me this means most sub-sectors of the markets (stocks, bonds, real estate, etc.) will have the wind at their backs over the coming months, as he has been vocal that the lack of inflation accelerating is a greater risk to the economy overall. I take this to mean the bar to hike short term rates in the future is far greater than one which will get him cutting again. And if I were a betting man… I’d bet that the next policy move in the future will be towards further interest rates cuts down the road. The Fed just doesn’t know it yet.
Sincerely,
Justin Kobe, CFA
Founder, Portfolio Manager & Adviser
Pacificus Capital Management
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Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated.Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond market is subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counter-party capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.