Volatility Gremlins

The term 'Volatility Gremlins' was coined by Ed Easterling of Crestmont Research to describe how volatility impacts the growth of investment portfolios. The term is perfect. Gremlins are annoying, but not particularly dangerous - unless there are a great many of them. They might take food while you aren't looking, or throw your laundry on the floor. Maybe they'll play little jokes on you, like hiding your keys, or your wallet. You wouldn't want one as a pet, but neither would you be frightened if you encountered one on a hike.

Volatility Gremlins play similar tricks with your portfolio. You may hear that markets have gone up by 8 percent per year, but you've only seen 5%. Your financial plan might say you can safely take $70,000 per year in retirement income, but your nest egg is shrinking more quickly than expected. What's going on?

Volatility Gremlins work by tricking you into thinking average returns are the same as compound returns. Let's work through an example.

If you experience returns of 5%, -15%, and 25% over three years, your average return over the 3 years is 5% per year. However, your compound return is just 3.7%. Those sneaky Volatility Gremlins snatch away 1.3% per year, or over 25% of your returns! Not so harmless now, eh? Table 1. and Chart 1. show more examples of how a wider disparity (or volatility) in returns results in lower compound returns, even while average returns are constant at 5%. The example above is 'Case E' below.

Table 1. Volatility Effect on Average and Compound Returns

Source: Crestmont Research, Butler|Philbrick & Associates

Chart 1. Volatility Effect on Average and Compound Returns

Source: Crestmont Research, Butler|Philbrick & Associates

Volatility Gremlins really hit above their weight class when you are taking money from your retirement portfolio to meet living expenses. In this case, the nasty critters can make off with a very substantial portion of your annual income, if you aren't careful. This is because of the impact of taking money from your portfolio during periods when it has declined in value. Money that is withdrawn when markets are down can not be used to help the portfolio recover.

So how much of your annual retirement income might Volatility Gremlins be snatching from your wallet when you aren't looking? The amount could be quite substantial. Chart 2. illustrates the impact of increasing levels of volatility on the retirement income of an average retiree.

Chart 2. Higher Volatility in Retirement Portfolio Results in Lower Safe Portfolio Income

Source: Milevsky (2005), Faber (2010), Shiller (2010), Butler|Philbrick & Associates. For Illustrative Purposes Only

Astute readers will notice that Volatility Gremlins get very excited at the idea of pilfering income from retirement portfolios. In Chart 2. we can see the effect of increasing volatility on a $1 million retirement portfolio which:

1. delivers 7% per year growth after inflation;
2. for a retiree who expects to live another 25 years, and;
3. who wants to be 85% confident that he won't run out of money.

Observe that a retiree with a low volatility portfolio, at say 7% annualized volatility (green bar), can safely withdraw over $71,000 per year. In contrast, a retiree with a volatile portfolio, at say 17% annualized volatility (red bar), can safely withdraw less than $52,000 per year. The Volatility Gremlins make off with 36% of the latter retiree's income!

I have spilled much ink describing ways for investors to lower risk in portfolios, so I won't go into the details here. You will note in Chart 2. that I make reference to Faber's Tactical Asset Allocation portfolio as a lower risk alternative. Readers who are interested in methods to capture robust returns while dramatically lowering portfolio volatility are invited to visit our web site (http://www.macquarieprivatewealth.ca/specialist/butlerphilbrick/case-studies) for more articles and studies.