Volatility vs. Risk

Volatility vs. Risk

Monthly Outlook: March 2018

In case you didn’t notice, February was a bit of a wild ride for stocks.  The S&P500 peaked on January 26th, dropped 11% by February 9th, then rebounded 8% by February 26th.  That’s a very unusual and large amount of volatility for one month!  We’ll talk more about volatility and risk later in this Outlook.  First, let’s review market returns for the month and year to date.

U.S. stocks (S&P500) lost -3.7% in February but are still up +1.3% YTD.  The strongest sectors continue to be Technology, Financials, and Consumer Discretionary (mostly Amazon!).  International stocks (FTSE All-world ex-USA) also had a yo-yo February and fell -5.3% for the month, but are up slightly, +0.1%, for the YTD.  Outside the U.S., it’s the Emerging Markets that show the most strength.  Lastly, let’s look at bonds.  Bonds (Barclays Aggregate Bond Index), are down -2.2% YTD and that includes interest.  As interest rates rise, bond prices fall.  And interest rates are rising, as seen by the U.S. Treasury 10-year rate rising from 2.4% to 2.9% this year, already.  With rising rates, it’s prudent to move to shorter-term bonds and you may have seen us make those trades over the last two months.  Whereas the medium-term bond average is down -2.2% YTD (noted above), the short-term bond average is only down 0.8% YTD.  It’s clear we’ve made the right move, so far, with our short-term bonds.

Volatility vs. Risk

With the return of volatility in February, it’s a good opportunity to review some fundamentals of investing.  It’s so easy to focus on annual returns, but “how you get there” matters a lot, as we were just reminded this past month.  The S&P500 showed a total move of nearly 20% in February only to end up -3.7%.  If you were watching every day, you might have been unsettled.  But if you only look month to month, you may be wondering what’s the big deal?  The biggest problem with volatility is that it’s unnerving and it can lead you to abandon your strategy.  It’s easy to extrapolate a brief period of volatility into a catastrophe in your mind.  While we don’t enjoy volatility, we don’t really see it – by itself – as a major concern.  Some investment textbooks link volatility to risk.  But we define risk differently.  Like you, most likely, we define risk as the possibility of losing money.  And volatility doesn’t necessarily equate to losing money.  No one seems to mind upside volatility, only downside volatility, right?

For that reason, we created our iFolios strategy to specifically focus on capturing upside growth, but to manage downside risk and reduce loss.  We do that by focusing every day on the long-term trend of each holding in your portfolio.  We don’t mind (too much) if a holding is a little volatile as long as it’s continuing to trend higher.  We’ll accept some “upside volatility.”  But if any holding starts to trend lower by dropping below its long-term trend, we consider that to be risk and we’ll sell or trim that holding for protection.  Clearly, we see volatility and risk as related, but not the same.  It’s interesting that February was certainly volatile, but did not trigger any sell signals; all holdings held above their long-term trends.  We’re still fully invested and poised for more growth.  When the volatility turns into risk, we’ll take appropriate action and get protective.

Looking Ahead 

We are carefully watching a lot of issues that could affect markets.  Just to name a few:  rising interest rates as a result of inflation risks, the effect of tax cuts on continued corporate earnings growth, rising inflation vs. the falling US dollar, how annual budget deficits are adding to national debt, whether the unemployment will start to rise from its current 4.1%, whether politics and politicians will be cooperative or disruptive, peak equity market valuations, and so much more.  These issues and many others will ultimately drive the hopes and fears of investors which will in turn drive the prices of investments.  Most importantly for us, we don’t have to predict or guess how these issues resolve.  We will see the results in the price trends of our portfolio holdings.  We’ll let the pundits backfill the story behind the market moves.  We are better served by carefully monitoring prices and trends and investing with the trend – whatever the reason.  We might have to accept a bit more volatility – but not more risk!