What You Don’t Know about Volatility Can Hurt You

If there’s anything that the global financial meltdown of 2008 taught us, it’s that risk management is important in any investment environment. If you don’t have a strong risk management approach to investing, you could be exposed to some potentially dangerous volatility.

In the investment world, while a little volatility can be good, too much of it can eat into your portfolio’s returns. This happens through something known as volatility drag (or volatility drain). What it amounts to is this: with all else being equal, the more volatile your return stream is, the lower the compound rate of return you will actually get, because it affects the way your returns compound over time.

Here’s an example. Let’s say Investor A has $100,000 and earns a 10% return over two years. His mean return is 10% per year, and he’ll have a cumulative value of $121,000. Let’s compare that to Investor B, who also has $100,000 but earns 30% the first year and negative 10% the second year. This person’s mean return is also 10%, but they’re left with a cumulative value of $117,000. Investor A earned a 10% rate of return, while Investor B only earned 8.2%. The difference came about because of volatility drag—the negative impact volatility has on returns.

This is where active management becomes really important.

In passive investing, you own the market—all segments of it, including the expensive, high-volatility, and low-quality portions. But with an active approach, a manager is required to not only pay close attention to risk but also have the right procedures and policies in place to make sure that a portfolio lines up with the investment philosophy and goals of the client.

In the ongoing oversight of a portfolio, an active approach puts a high priority on risk management. And because of this, the active manager can choose which securities or asset classes might provide a better return for the risk being taken—as well as potentially choose not to invest in expensive or highly volatile securities. In other words, they may reduce unwanted volatility.

You’ve probably heard the old saying, “one of the best ways to win in investing is to keep from losing.” What this also means is, “try to lose less when the markets are heading south.”

At Lucia Capital Group, we discuss the impact of market volatility and show you ways to potentially reduce risk. In the midst of a 10-year bull market, now is the time to take action.

Give us a call, we’re here to help.

Information presented should not be considered specific tax, legal, or investment advice. You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

No client or prospective client should assume that the information contained herein (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group, its investment adviser representatives, affiliates or any other investment professional.

Raymond J. Lucia Jr. is chairman of Lucia Capital Group, a registered investment advisor and CEO of its affiliated broker-dealer, Lucia Securities, LLC, member FINRA/SIPC. Advisory services offered through Lucia Capital Group. Securities offered through Lucia Securities, LLC. Registration with the SEC does not imply a certain level of skill or training.

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