Losses & Volatility Are Not The Same Thing

A while back I was having coffee with a financial professional, and he was chatting about the need to reduce volatility. I innocently asked if what he was saying was “if a person had a choice between an investment that plugged along paying 5% every year versus one that could make 2% to 20% every year, are you saying the person should choose the 5% one because the other one was more volatile?” He quickly responded by saying, “No, upside volatility is a good thing.”

The point is this gentleman wasn’t really talking about avoiding volatility; he was talking about avoiding losses. Losses are an entirely different thing from volatility.

There’s a lot of talk on the financial channels about minimizing or managing stock market volatility, and generally it sounds like they think you should avoid it, but what they really mean is trying to limit the size of the loss. The way they typically try to do it is by splitting up the money between different securities and either let it pretty much sit there (also known as asset allocation) or they try to time the market by moving between different securities on a more active scale. Their goal is to keep score of how much volatility there is, because they believe that rising volatility makes losses more likely. How well do they do at avoiding losses by managing the volatility? Good question. Since the market has been heading up since 2009, there haven’t been any recent tests to see whether this all works. I guess we’ll find out when the next bear market occurs.
 
There is a way to avoid volatility altogether and that is with a fixed rate annuity. This annuity pays a stated interest rate for a stated number of years and at the end of the period you can either keep it in the annuity or move it someplace else. Of course, it doesn’t offer the upside potential of securities, but the last time I looked many of them were very competitive against certificates of deposit yields.
 
A fixed index annuity eliminates downside volatility – you can’t lose what you have if the stock market goes down, but it keeps a bit of upside volatility in that the interest earned may be quite a bit higher than the fixed rate annuity earns. This combination of protection and potential explains why an estimated $50 billion of fixed index annuities were purchased last year.
 
Wall Street folks seem to have a tough time saying the “L” word (loss), so they instead call it downside volatility. However, volatility is an entirely different thing. For example, with the fixed index annuity you benefit from volatility because it means you could earn more interest (and since it’s a fixed annuity you never have to worry about the “L” word).  As that financial professional said, “upside volatility is a good thing.”

---