VOLATILITY and CORRELATION: How they Impact your Investment Success -Part 1 of 2

On November 13, 2019, Julie Brough, Executive Vice President & Portfolio Manager at Logan Wealth Management, hosted a webinar covering the fundamentals of how volatility and correlation affect your financial portfolio. This presentation was entitled: Volatility and Correlation: How they Impact your Investment Success

PART 1 OF 2

What is volatility? What is correlation? What is path risk and how does it impact your portfolio? Why is it difficult to recover from a downturn especially if you are withdrawing from a portfolio?

Volatility and Correlation are factors that have a substantial impact on investment success.

What is Volatility? Volatility is a statistical measure of the dispersion of returns for a given security or market index. (Source: Investopedia.com). Volatility is simply how broad the swings are in share price.  We tend to think about it in terms of downside risk because that’s what causes us the most concern, but it is, in fact, the swing in both directions and it includes upside potential.

What is Correlation? Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. (Source: Investopedia.com). Correlation evaluates the relation between two securities.  It is a measurement of the degree to which those two securities move in tandem with each other. 

A General Guideline When you are building a portfolio, you want it to have securities that are not correlated so you get the value of diversification. There are mathematical formulae to calculate volatility and correlation but for our purposes here, we’re focusing on the concepts.  (And, an Excel spreadsheet can create the formulae for you.)

Why does Volatility matter? In an ideal world your returns on investment would follow a straight line, and you would always reap the benefit of compounding interest. In reality this doesn’t happen due to volatility.  When share prices decrease because of volatility you lose some of the value of compounding interest.  This impacts your rate of accumulation, or if you are withdrawing from your portfolio, it affects your rate of decumulation.

Path Risk Related to volatility is path risk.  This is the pattern of the rates of return over time.  If you have really good rates of return at the start, you will have an increased likelihood of financial success compared to someone who gets the same overall average rate of return as you, but who has lower rates of return at the start. 

Let’s look at an example: 2 different investors with the same initial investment and the same amount to be withdrawn yearly.  The only difference between them is that they retire 3 years apart. What do their portfolios look like after 10 years?

Figure 1

Figure 2

From Figure 2 we can see that after 10 years, the portfolio of Unlucky Investor A, who retired in 1999 at the end of the booming ‘90s, is only worth $400,000, while that of 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.

Even if we look at 13 year period and assume that Lucky Investor B was investing (but not yet withdrawing) during the years after the tech bubble burst in 2000, and that they incurred losses, they would still be in a stronger position relative to where Unlucky Investor B would be after 13 years, as illustrated in Figure 3.

Figure 3

Figure 4

As you can see from Figure 4, it matters when you start.  Unlucky Investor A started off with 3 negative years while Lucky Investor B started with 3 positive years.

It is difficult to recover these losses, and when you’re withdrawing it becomes even tougher.  The middle column of Figure 5 illustrates the return that’s required to recover your initial investment.  The last column shows that when you add the withdrawal requirement, the rate soars even further.

Figure 5

Figure 6 gives us another way of looking at this.  The average annual rate of return was 1.77% for Unlucky Investor A over the 13 year period between 2000 and 2012.  If they had incurred that same meagre amount of return in a straight line, they still would have done better than they would have with the volatility they experienced.

Figure 6

Key takeaways regarding Volatility – Plan for the Worst and Hope for the Best

We have to accept some volatility and path risk in our investment plans since most people cannot afford to live out their retirement on the returns available from GICs.  Proper planning is essential and it involves figuring out your line in the sand, i.e. what is the lowest amount your portfolio can drop to and you will still be able to maintain your lifestyle through retirement?  You need to understand the limitations of your own ability to absorb financial risk.  This becomes the foundation for how much risk you can have in your portfolio.  As long as it stays above that number, you will be fine.  So, plan for the worst and hope for the best.

Summary and What to expect in Part 2 of this webinar blog

In this first part of the presentation, we’ve defined what volatility and correlation are.  We’ve looked specifically at volatility and the related concept of path risk.  Through an example, we’ve illustrated that it matters when you start, recovering is tough, and volatility has an impact on accumulation.  The lesson here is that we need to understand our ability to absorb financial risk, and we need to plan for the worst and hope for the best.

In the second part of this webinar, we will look more closely at correlation, and at some of the main ways to diversify a portfolio.

Disclaimer: Please note that the information presented here is intended as general information only.  It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as investment advice. Please consult your adviser to determine whether this information is applicable to your personal situation.