Every Good Investor Uses Volatility and Correlation to Increase Their Success. You Should Too.

No matter when, how, or where we invest our money, we’re all looking to maximize our returns and minimize risk. Figuring out a strategy that works for you is not always easy but there are two factors to keep in mind that universally apply to every portfolio. They are volatility and correlation.

First, let’s go over what these concepts mean.

Volatility is the amount an asset’s price or value moves up and down. The volatility of an asset is determined by how high and frequently its spikes occur over a period of time. Since the future of an asset cannot be predicted, investors use historical volatility to create an investment strategy to optimize the expected return of a portfolio, given the overall risk level.

Correlation is a measure that describes the relationship between two securities. Highly correlated securities usually move together. And securities with low correlation, usually don’t. Sometimes when securities with high correlation are moving together, it’s because they’re sensitive to similar events, such as political or market changes. Investors build strong portfolios by choosing securities that have a low or negative correlation.

Now, let’s go over how volatility and correlation can impact you.

Volatility is a reality of investing. Whether you invest in tech, banking, or retail, when share prices decrease (which can be more dramatic for securities with high volatility), you lose some of the value of your portfolio. So, if you were to withdraw at a moment of loss, it will have a larger impact on your portfolio than you might have planned. You can’t avoid it entirely, but you can reduce how much one world event will affect share prices across your portfolio. You can do this by diversifying, also known as investing in securities with low correlation. Over the long term, a diversified portfolio will have lower overall volatility, yet each security class will still generate its own optimal return.

Alright, so in summary, understand how volatile your assets are so you know how much risk you’re taking on. Then, make sure you’re diversifying your assets so that a single event in one industry or part of the world doesn’t impact them all.

Let’s keep going and move on to path risk. This is the pattern of the rates of return over time. An investor with good rates of return at the start will have an increased likelihood of success over an investor who does not, even if the overall average rate of return is the same.

In the world of investing, the investor who does not start out with good returns is known as Unlucky Investor A. The investor who does is known as Lucky Investor B.

Let’s look at how volatility impacted their portfolios over 10 years with Unlucky Investor A retiring at the end of 1999 (we all know what happened there) and Lucky Investor B retiring at the end of 2002.

Let’s look at the data. After 10 years, Unlucky Investor A, who retired in 1999 at the end of the booming ‘90s, is only worth $400,000. While Lucky Investor B, who retired in 2002, is worth almost $1,400,000. These are radically different outcomes for the same initial investment and rate of withdrawal.

When you look at the returns on a year-by-year basis, it’s even more evident that it matters when you start. In this case, Unlucky Investor A started off with 3 negative years while Lucky Investor B started with 3 positive years.

You might be thinking, wouldn’t it just take more time to recover but eventually, it will, right? In a way, yes. But not when you compare the numbers to Lucky Investor B. With certain unlucky events, it can be difficult to recover the losses, and when you’re withdrawing it becomes even tougher. The middle column illustrates the return that’s required to recover your initial investment—numbers that are quite high. The last column shows that when you add the withdrawal requirement, the rate soars even further.

So, here’s what we’ll leave you with—plan for the worst and hope for the best. Plan for the worst by avoiding high correlation assets as it will increase your portfolio volatility, and increase path risk. By mitigating these factors, you reduce the chances of finding yourself in an unfortunate financial situation. That being said, hope for the best. We all must accept some volatility and path risk in order to reach retirement with enough savings, the key is understanding our personal limitations. What is the lowest amount your portfolio can drop to and still allow you to maintain your lifestyle through retirement? Knowing that will allow you to take on a healthy amount of risk and construct a successful portfolio for your future. Talk to your financial advisor today to build a portfolio that’s right for you.