So, you are ready to invest? The following is a good mental exercise. Given the choice between an investment expected to return 15% annually over the next 5 years and one expected to return 20% over the same time, which would you choose? When posed this question, many people envision a chart like the one below.
All other things being equal, who wouldn’t opt for the higher return, right? But all other things are not always equal; in fact, investments with steady annual returns of 20% year after year are very rare. Investments experience volatility. Stocks, bonds, and commodities all have good periods and bad periods, and it is apparent to anyone who watches markets on a regular basis that higher returns almost always come with higher risk and higher volatility.
Let’s add some random volatility to our hypothetical investments to make them look more realistic. Below is a chart of two returns: the blue line still has an annualized return of 15%, and the orange line still returns 20%.
Still picking the 20% investment? Before you decide to put your hard-earned money to work, imagine how you would feel investing your money in the orange line. Take a look at those early drops highlighted in green. The first, which takes place during the initial month you have invested your money, is a 41% decline. Declines like that do happen—not that frequently or always that quickly, but they happen. If you saw your $100,000 investment drop to below $60,000 four weeks after you invested it, would you have the patience to stay the course? If you sold out then, you would miss the rebound. And if you did hold out, how would you feel about that second drop a few months later, which is almost 66%?
If your answer is still, “Yes, I can handle some volatility for the additional return,” and “I’m in for the long haul,” consider the same investments in the chart below, this time with two different areas highlighted. The highlighted circles are three years apart and identify a time when a series of poor months drops the investment value to a point below its level three years prior. Imagine if the chart ended there. Are you still holding on when you have taken a bunch of huge drops and are now back to nearly the same investment value as when you started? Your annualized return is near 0%. At this point the lower volatility investment (blue line) is up by about 75%!
Some investors don’t mind even that extreme kind of volatility and are able to maintain confidence in the underlying assumption that their riskier investments will continue to perform. Many others find it much more difficult. Investors need to be compensated (with higher returns) for assuming higher levels of risk. But how much “extra return” is right for the increased risk? No two investors’ risk tolerances are the same. That’s why a very important aspect of investing is selecting the right investments for you.
At VMI, we have decades of experience in the markets and generations of financial planning know-how that help us guide clients in the selection of investments that best meet your tolerance for risk, as well as a myriad of other considerations. The best investment choices are not always those with the highest expected returns. And the best investment advisors are the ones who can help you reach your financial goals with choices that will allow you to sleep well at night along the way.
Jim, Mark, and Dave
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