Volatility — The Retirement Killer

August 20th, 2011 by John Anderson – Be the first to comment
Posted in Investing, Market Turmoil, Volatility

 

Volatility refers to how much stock prices vary over a given time frame, usually a year. The current renewed volatility in financial markets is reviving a lot of unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing more harm than good.

At its core, the increase in market volatility is an expression of uncertainty. Nobody knows what’s going to happen next. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants flee to what they consider to be less risky assets.

The problem for most investors with a long range-purpose, such as retirement, is that the huge swings in the market can wreak havoc on your portfolio if you’re not prepared.   The events of 2008 left many Americans wondering if they are ever going to be able to retire. Now, with the markets continuing to churn and memories of huge losses fresh in the minds of investors, many are looking for a safe place to park their money while still needing it to grow.


So How Bad is It?

Let’s keep this is context.  We’ve been through worse and lived to tell the tale.  As I write this, the market, as represented by the S&P 500, is down roughly 17% from its high earlier this year.  Nobody wants to repeat the experience of the 2008 financial meltdown which is why there are so many “running for cover”.    In 2001-2002 we saw comparably sharp and sudden declines.  Before that, we have to go back to 1987 to find comparable losses on the same scale.  Both periods are known for being strong bear markets.  Only time will tell if that is where we are today.

Volatility and the “Fear Factor” Index

What does volatility look like today compared to history?  Perhaps the best estimate and measure of volatility can be found in the options market.  The prices of options on a stock, ETF, or index tend to reflect the consensus view of future volatility.   The index that tracks volatility of the U.S. stock market is known as the VIX Index.  The VIX Index is often referred to as the “fear factor” index as it tends to spike during times of market turmoil when investors are panicking.

The "Fear Factor" Index

The VIX Index

In the above chart of the  VIX Index, we can easily see that the past few years have been very tumultuous as represented by the spikes in the graph.  Also notice, we are currently experiencing volatility at levels equal to the early part of the 2008 meltdown (represented by the blue line I’ve drawn across the top).  All that to say, that these huge swings in the market can make for some sleepless nights, heartburn and a lot of anxiety if your portfolio is not prepared to handle it.

What This Means to You and Your Retirement

The first question you might ask is “How did we get here”?  Let’s step back and look at the big picture.  You might remember the huge boom years of the 90’s when stock prices soared.  Most of that boom was driven , retrospectively,  by unrealistic speculation – primarily in tech stocks, and a dangerously complicated and unregulated derivatives market.  All of the speculation drove stock prices far above reasonable, sound and fundamental valuations.  It all had to come to an end sometime and that’s what we’ve experience over the last decade.  First the tech bubble in 2001 and finally to a large degree the derivatives bubble in 2008.  The latter being a much bigger mess.

So where does that leave us?  Markets work and they are efficient, which can be both good and bad – depending on where you find yourself in the cycle.  We are still in the laborious process of absorbing all of the baseless speculative value created during the 90’s.  It has taken approximately ten years at this point and the bad new is it will probably take many more years to finally catch up.  More on why at another time.  Long gone are the times when you could just throw your money at the market and potentially make nice returns.  It means you now have to look at the global picture and understand how the different assets in your portfolio work together to manage risk and generate return.

Plan Ahead for a Bumpy Ride

The second question you might ask is “What do I do about it?”   First, the bad news, you need to steel yourself for a bumpy ride and more volatility.  Review your  asset allocations and make sure you’re positioned to ride out the storm and even potentially profit.   The purpose of your asset allocation is to maintain a targeted risk level.  It’s time to take a long hard look at your portfolio and decide how much risk (i.e., volatility) you can stomach and adjust accordingly.  The best bet, make sure you have asset allocations with low correlations to each other.  Take time to understand the financial landscape and make sure you’re well positioned for a higher-volatility future.

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Standard Disclosure:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Investing involves risk including loss of principal.