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Victoria, TX 77901

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Balancing Volatility & Return

George called wanting a second opinion.

He and his wife, Kim, had been to see a financial advisor in hopes of increasing their returns. The interest on their certificate of deposit was negligible. As such, they were open to other ideas—even if it involved putting funds to work in the stock market.

In the past George had “gambled” with money in certain stocks—trying to trade in and out. As to be expected, this did not turn out too well.

At Kim’s insistence, the couple was now looking for a longer term approach. However, he was quite surprised when the advisor told him that in order to be a successful long term investor he should be willing to tolerate shorter term volatility in order to earn longer term returns.

The advisor went on to tell George that he needed to be prepared to see his stock market assets fall by 40% in any one year and by 60% over a two year period in order to gain the benefit of the long term averages. George thought this was crazy and was sure the advisor was wrong.

In our opinion, the advisor was correct. And George’s response is quite typical.

We explained that six times in the past fifty years the US stock market has fallen by at least 30% over a twelve month period. On a few occasions, it has fallen by 60% over a 24 month period. And yet, over long time frames—generally 10 or more years--it still delivers returns that allow wealth creation in excess of taxes and inflation.

Furthermore, we discussed that the long term value of a business is generally determined by the amount of money a company makes. Despite this, many good companies will still see their stock price fall over short periods even if they continue to earn more and more money during a downturn.

George countered and said that he’d be better off investing in a 10 year US Treasury Bond which is “risk-free.”

In assessing this we pointed out to George that a 10 year Treasury would pay him interest of about 2.5% per year. And then he would owe income taxes on this return. In George’s case it would trim his return by 40% leaving him with 1.5% after tax.

Then we asked George about the impact of inflation. George was silent.

If you accept the governments metric, then inflation is running about 2.1% currently. This would mean that George’s purchasing power would actually decline by .6% each year over the next ten years.

George started to realize that his idea of a “risk-free” investment was riskier than he thought as it guaranteed a long term erosion of his purchasing power.

Furthermore, we were able to explain that there are many types of risk present upon a portfolio every day. Focusing all of your attention on just one type of “risk” can leave an investor far more exposed than they realize.

It ended up being a very productive conversation in which we were able to make a few key points.

Many people think they know what will happen in the stock market over short periods of time. None have proven long term success at such prognostications.

Volatility is not the same thing as risk. Risk comes in many forms and cannot be avoided. Rather it must be managed.

Short term liquidity and cash flow needs must be balanced against longer term growth demands. Most investors achieve the best results by having balanced and diversified portfolios.

The stock market is guaranteed to be volatile—especially over shorter periods of time. Successful stock market investors focus on where they want to be ten or more years from now. Furthermore, they do not allow short term bumps to disrupt the long term plan.

Dave Sather is a Victoria Certified Financial Planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.

Originally published October 7 2014, Victoria Advocate