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Wall Street defines risk as volatility. The more a fund or portfolio fluctuates in value, the riskier it is deemed. The vast majority of individual investors define risk differently. Individual investors, in aggregate, define risk as the chance of losing money.
Both definitions are correct. If time horizons are very long or infinite, then the degree to which a fund or a portfolio fluctuates does not matter as long as the expected gain is large enough. This viewpoint works very well for developing mathematical equations. Whenever expected returns and volatility can be specified, a quantitative model can be constructed to determine whether it is logical to expect an investor to be compensated for the amount of risk taken. The Sharpe ratio is an example of this type of model.
Human emotions are far different than the logic underlying mathematical models. We view losses and gains differently, as Nobel laureate Daniel Kahneman and Amos Tversky documented. Specifically, they found that people will not act in their economic best interest in order to avoid a sure loss. This is because we humans feel greater pain from losses than pleasure from gains.
If mathematical models treat gains and losses equally, but humans derive more pain from losses than pleasure from gains, then a disconnect clearly exists. Some academics and practitioners have tried to resolve the difference by creating of various measures to assess risk.
One of them is the “Pain to Gain” ratio. Recently on the Financial Planning website, Craig Israelsen explained this formula. It divides the standard deviation of return by the actual return. The standard deviation, in this case, is the amount an asset’s return deviates from its typical range of returns. You can calculate it by downloading return data from a website such as Yahoo Finance and using the “STDEV” function in Microsoft Excel. In describing the indicator, Israelsen wrote, “We want to experience less volatility (pain) for a given level of return (gain)—so the lower an investment’s score, the better.” (Israelsen used rolling 10-year period returns in his article, but told me in an email that 36-month periods can also be used. The more common practice for calculating risk measures is to use monthly returns for the past 36 months.)
At AAII, we use a similar but slightly different measure: the risk index. This is the standard deviation of a fund’s or portfolio’s return divided by the standard deviation of return for a benchmark. The benchmark can be a broad market index (e.g., the Dow Jones U.S. index) or a fund’s category average. A score of 1.0 indicates greater risk than the index and values below 1.0 indicate lower risk. This measures tell you whether or not a portfolio (or a fund) has incurred greater price volatility than its benchmark.
Knowing how relatively volatile a portfolio (and/or a fund) is can help you adjust your investment strategy to allow you to sleep better at night. But volatility works in both directions. What matters to most investors is how much downside volatility there is. One measure of downside volatility is the Ulcer Index, a more complex mathematical equation that considers the retracement in value (or price). A simpler rule of thumb is to compare monthly drawdowns between a portfolio or a fund and an appropriate benchmark. Another rule of thumb would be to calculate the risk index for up and down months; this would reveal whether the excess volatility is incurring on the upside (a good thing) or on the downside (which could fray your nerves).
The big thing to remember is that you have to be willing to accept downside volatility if you want to build long-term wealth. A savings account will ensure your wealth never drops in absolute terms (as long as you don’t make withdrawals), but you will lose out to long-term inflation (prices will rise at a faster pace than your savings will grow at). A portfolio composed entirely of stocks will give you the largest amount of growth over the long term, but your net worth may rise and fall significantly over the shorter term. In between are a wide range of allocation options, each with varying degrees of risk and reward. Finding a mix that keeps the pain of downward market moves at a tolerable (not comfortable, but tolerable) level can help you achieve your long-term goals.
- Don’t Over-Rely on Historical Data to Forecast Future Returns – William Sharpe gave his thoughts on how to use the risk measure (the Sharpe ratio) named after him.
- Grappling with Fund Risk – This AAII Investor Classroom lesson discusses how to judge a fund’s risk.
- The Ulcer Index – This measure of downside volatility was explained in greater detail in our Computerized Investing publication.
- How Much Attention Do You Pay to Volatility? – Tell us on the AAII.com Discussion Boards.
Approximately 25 members of the S&P 500 will report earnings next week. Dow components Home Depot (HD) and Wal-Mart Stores (WMT) will report on Tuesday, along with several other retailers throughout the week, including Target Corp. (TGT) and Lowe’s Companies (LOW) on Wednesday.
The first economic report of note will be the National Association of Home Builders’ May housing market index, released on Monday. Tuesday will feature April housing starts and building permits. The minutes from the April Federal Open Market Committee meeting will be released on Wednesday. Thursday will feature April existing home sales and the May Philadelphia Federal Reserve’s manufacturing survey. The April Consumer Price Index (CPI) and the PMI’s May manufacturing flash will be released on Friday.
Chicago Federal Reserve bank president Charles Evans will speak publicly on Monday and Wednesday. San Francisco president John Williams will speak on Thursday.
The Treasury Department will auction $13 billion of 10-year inflation protected securities (TIPS) on Thursday.
- 16 Financial Ratios for Analyzing a Company’s Strengths and Weaknesses
- The Cash Flow Statement: Tracing the Sources and Uses of Cash
- Munis vs. Taxables: How to Determine the Taxable Equivalent Yield
Optimism set a new two-year low for the second consecutive week in the latest AAII Sentiment Survey. Neutral sentiment stayed above 45% for a sixth consecutive week, tying a 27-year record, while pessimism declined slightly.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 0.3 percentage points to 26.7%. This is the lowest level of optimism since April 11, 2013 (19.3%). Bullish sentiment remains below its historical average of 39% for a 10th week in a row. This streak is the longest since an 11-week stretch between March 20 and May 29, 2014.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 0.8 percentage points to 46.9%. The increase keeps neutral sentiment above 45% for the sixth consecutive week and above its historical average of 31% for the 19th consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, fell 0.5 percentage points, to 26.4%. This is the 16th week this year where pessimism has been below its historical average of 30.0%.
The current streak of six consecutive weekly neutral sentiment readings at or above 45% ties a record last set in 1988. Neutral sentiment stayed above 45% on consecutive weeks between May 13 and June 17, 1988. It was at or above 45% on consecutive weeks between January 22 and February 26, 1988. (Prior to 2000, the sentiment readings were rounded to the nearest full digit.)
Bullish sentiment remains at an unusually low level, while neutral sentiment continues to stay at an unusually high level. Historically, such readings—both unusually high low bullish sentiment and unusually high neutral sentiment—have been correlated with better-than-average market performance over the following six- and 12-month periods. (See Analyzing the AAII Sentiment Survey Without Hindsight in the June 2014 AAII Journal for more information.) There is no guarantee history will repeat itself in the future, however.
Causing some AAII members to be cautious or pessimistic are prevailing valuations, recent price volatility, geopolitical events, the pace of economic growth, the impact of the stronger dollar on earnings growth and worries that a notable decline in stock prices could occur. Keeping other AAII members encouraged are the ongoing bull market, sustained economic expansion, earnings growth and still-accommodative monetary policy.
This week’s Sentiment Survey special question asked AAII members how the rebound in oil prices has impacted their six-month outlook for stock prices. About 12% of respondents said that the rebound affected their outlook negatively. Approximately 27% said that the increase in oil prices affected their outlook favorably. The majority of respondents, 61%, felt that the change in the price of oil has not altered their outlook.
Here is a sampling of the responses:
- “The oil market improvement has not really affected my outlook. The present international situation, the Federal Reserve intervention and slow growth of the economy have the most impact on my outlook.”
- “No, I’m more focused on corporate earnings and GDP growth.”
- “Very little. I think the underlying competitive struggle between U.S. and Middle East (particularly Saudi Arabia) will leave the price movement neutral on average over the period.”
- “Modest increases in oil prices should have a positive impact on stock prices.”
- “Bullish impact because the partial rebound in oil prices will partially reverse the dramatic downturn in the energy sector caused by the oil price collapse.”
- “Negative impact on market due to fewer investment dollars.”
Bullish: 26.7%, down 0.3 points
Neutral: 46.9%, up 0.8 points
Bearish: 26.4%, down 0.5 points
Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Local Chapter Meetings
May 7, 2015 Valuations Are Higher, but So Are Margins
April 30, 2015 A Dot-Com Crashes After the NASDAQ Sets a New High
April 23, 2015 Wealth and Spending Affect the Success of the 4% Rule
April 16, 2015 Buck Conventional Wisdom When Taking Retirement Withdrawals
