Volatility is a fact of life when investing in the stock market.
As indicated in the chart below, the Chicago Board Options Exchange volatility index has had six meaningful spikes (index levels exceeding 30) since 1990, with by far and away the most extreme spike occurring over the past couple of years.
Each of the high volatility periods below is correlated with a swoon in stock prices.
Although periods of high volatility produce gut-wrenching headlines and loads of anxiety, one might ask why volatility really matters. After all, things seem to work-out relatively well for those who are able to stick with their equity investments over very long time horizons.
The reality is that when it comes to volatility, timing is everything and there is enormous risk if one is forced to start making withdrawals from a portfolio during a period of when asset prices are fluctuating wildly. Portfolios and retirement spending plans are simply unlikely to recover from the effects of sequence of returns risk or a blow delivered at the wrong time.
Sequence of returns risk describes a situation in which poor investment returns at the general time of retirement (e.g. plus or minus 5 – 10 years before or after retirement) jeopardize the likelihood that a planned level of spending will be sustainable throughout one’s entire retirement.
In other words, as millions of Baby Boomers have experienced over the past couple of years, longevity risk and the likelihood of ruin in retirement increase significantly if: a) one has meaningful, un-hedged equity exposure in an investment portfolio, and; b) equity market volatility happens to roughly coincide with the onset of retirement.
Future additions to this post will provide specific examples of the relationship between sequence of returns risk and planned levels of retirement spending.
- tom's blog
- Log in to post comments
Comments
Jim replied on Permalink
Why so Concerned about Volatility
Each of the volatility spikes displayed in the chart have been followed by asset prices returning to or exceeding previous levels.
Why get so concerned about periods of volatility if the effects on assets prices are temporary?
If anything, the spikes present a buying opportunity.
Anonymous replied on Permalink
Volatility is fine if you don't need income
If you take a retiree from ten years ago and say they have a portfolio that was worth $1,000,000 in 1999. They need $50,000 a year from their investments to support the lifestyle they would like throughout there retirement years. That is a 5% withdrawal rate based on the beginning portfolio balance.
If they had used this strategy and followed the performance of the S&P 500 there portfolio would only be worth $525,000 today. Just 10 years into retirement and now the withdrawal rate has moved from 5% to almost 10%. Their risk of outliving there money is significantly higher now.
This is a huge flaw in retirement income planning to ignore the risks of volatility. Higher volatility reduces compound returns. The compound rate of return over the past 10 years has been negative which is leaving retirees very little flexibility with how they invest their money.
This couple, assuming they need the above income and continue to take the income will NEVER recover from the losses. Had they purchased an annuity with a portion of there money 10 years ago they would not be facing this financail disaster that is the result of mass media and wall street advisors suggesting that Stocks and bonds, asset allocation are the only way to invest.
People generally buy the POTENTIAL Returns that are illustrated to them when they plan, but they do not buy the risk and furthermore I don't believe they understand the risk that they carry.
Middle class americans, in my opinion, should first be constructing a retirement plan that secures there income needs and then investing the remainder of the capital for long term growth.
tom replied on Permalink
Volatility
Great comment--thank you.