Understanding Market Volatility The inherent nature of capital markets is that they are volatile to varying degrees. Understandably, whipsaw market conditions are a source of investor anxiety. In such environments, the natural bias is to limit volatility, which can help prevent a loss in portfolio value and preserve capital.
Your objectives and the amount of risk you are willing to tolerate to achieve them are at the heart of our philosophy as fiduciaries. What is volatility and how is it defined? Volatility, or risk, is an inherent aspect of capital markets and typically is defined as standard deviation. deviation is a mathematical representation of how much variation exists from an average. A small standard deviation means that a set of data points are tightly knit. A large standard deviation means that a set of data points are spread out over a broad range. Visually, you may know standard deviation as the bell curve. Dispersion and variance are also common financial terms used to define volatility in capital markets. Why would volatility influence your portfolio decisions? Volatility is a useful tool that can help you set expectations for possible outcomes. For example, since 1926 and using annual data points, the S&P 500 has experienced 20% volatility. 1 If we use a long-term average return on the S&P 500 of 12%, you can reasonably anticipate a range of outcomes from an 8% loss to a 32% appreciation over a one-year period and approximately two thirds of the time. Put another way, this represents a range of returns +/- 20 percentage points over or under the average, or, within one standard deviation of the series average. The given range of possible outcomes is an important variable in determining risk tolerances. How can volatility affect the outcome of your portfolio? Another way of looking at the problem is by demonstrating how volatility can erode wealth over time. The table below depicts two portfolios with a beginning value of $10 million, and both averaging an 8% return annually, over a 10-year time horizon. As you can see, Portfolio 1 generates approximately $2.2 million more than Portfolio 2 due to the consistency of returns. Volatility Can Diminish Wealth Portfolio 1 Balance ($ Millions) Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Avg. Annual $10.0 $10.8 $11.7 $12.6 $13.6 $14.7 $15.9 $17.1 $18.5 $20.0 $21.6 8.0% Portfolio 1 s N/A 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Portfolio 2 Balance ($ Millions) $10.0 $11.2 $11.7 $11.7 $13.5 $12.2 $15.3 $15.6 $17.8 $14.3 $19.4 8.0% Portfolio 2 s N/A 12.0% 4.0% 0.0% 16.0% -10.0% 26.0% 2.0% 14.0% -20.0% 36.0% For Illustrative purposes only. 1 Strategas, as of December 31, 2011. Past performance does not guarantee future results. You cannot invest directly into an index.
Volatility Can Diminish Wealth $25 Portfolio 1 Portfolio 2 $22 $19 $21.6 $19.4 $16 $13 $10 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Source: Strategas, December 31, 2011. For illustrative purposes only. Are investments worth the volatility? Typically speaking, the more volatility an asset class experiences, the more return is expected from that asset class over time. As you can see below, the long-term returns of equities have outpaced those of cash, corporate bonds and government bonds. However, it is important to note that the equity returns are not without excess volatility. For instance, large-cap stocks on average have nearly double the annual return of corporate bonds. By comparison, large-cap stocks have also nearly twice the volatility. Similarly, small-cap stocks have averaged annual returns nearly three times that of corporate bonds but, comparatively, have almost four times the volatility. Typically, the investment can be worth the volatility, but the time horizon is equally as important as the expected gains. Meaningful appreciation over longer time horizons has proven to offset short periods of volatility and loss of portfolio value. Asset Class Breakdown (%) Since Inception* 1925-2011 Last 30 Years 1981-2011 Last 20 Years 1991-2011 Last 10 Years 2001-2011 Last 5 Years 2006-2011 Average 30-Year 20-Year 10-Year 5-Year Large-Cap Stocks Small-Cap Stocks 11.8 20.2 12.5 17.0 9.6 18.6 5.0 19.4 2.4 21.5 16.5 32.3 13.5 20.7 13.3 20.7 10.2 25.7 2.8 24.9 Corporate For Illustrative purposes 6.4 Bonds only. 8.3 11.3 10.1 8.5 7.8 8.4 5.3 9.0 5.8 Government Bonds 6.1 9.7 11.8 12.8 9.5 12.2 9.6 11.9 11.8 15.4 Cash (T-Bills) 3.6 3.1 4.7 2.9 3.2 1.9 1.8 1.7 1.3 1.8 Source: Strategas, December 31, 2011. Past performance is not a guarantee of future results. An investment cannot be made directly into an index. *Since Inception date of December 31, 1925. Average and are comprised of 86 annual observations. www.atlantictrust.com Page 3 Understanding Market Volatility
Investments in the U.S. Capital Markets Year-end 1925 = $1.00, through year-end 2011 $100,000 $10,000 Small-Cap Stocks $1,000 $100 $10 Large-Cap Stocks Corporate Bonds Gov't Bonds T-Bills (Cash) $1 $0 1925 1935 1945 1955 1965 1975 1985 1995 2005 Source: Strategas, December 31, 2011. This is a logarithmic chart and may be more effective than other types of charts in illustrating changes in value during the early years shown in the chart. The vertical axis, the one that indicates the dollar value of an investment, is constructed with each segment representing a percent change in the value of the investment. In other words, the space between $1 and $10 is the same size as the space between $10 and $100, and so on. Should you use volatility to time the market? While anticipating volatility is common, using volatility to predict market behavior is difficult, because information is typically imperfect and idiosyncratic. As an example, just because a market falls 10% doesn t mean it won t fall another 10%. Similarly, waiting for a better entry point because a market has appreciated can work against you, because the market can appreciate further. Ideally, you will take advantage of mispricing events in capital markets to add value over time. However, attempting to time the market in the short term is a risky proposition where the opportunity cost is quantifiable and not likely to be in your favor. The following graph illustrates the risk of trying to time the market: S&P 500 Index s S&P Calendar Year Top Ten Up Days (Sum) Top Ten Down Days (Sum) 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% 2009 2010 2011 2012* Source: Strategas, December 4, 2012. *Estimate. Past performance is not a guarantee of future results. An investment cannot be made directly into an index. As you can see, fewer than 10% of the trading days account for a significant amount of upside and downside in a given calendar year. Put another way, you have a 20-in-252 www.atlantictrust.com Page 4 Understanding Market Volatility
(trading days) chance that you ll pick the direction and timing accurately when the impact is greatest. The odds are heavily stacked against you if that is your discipline. While it is tempting to think you can accurately predict this behavior through past experiences, the reality is that investing in such a manner is irrational. What can you do to harness volatility? Atlantic Trust s philosophy is that discipline and diversification are critical building blocks in any investment process. Without a framework for a long-term investment program, the chances of success are relatively small. Constructing a portfolio with a broad array of asset classes is critical to generating consistent, less volatile returns, which can facilitate capital growth and preservation in the long term. However, even the most diversified and well thought out portfolios are subject to volatile markets. Our investment professionals and relationship managers ensure they maintain an active management bias. This bias provides us with the flexibility to manage asset allocation and manager selection within the constraints of client guidelines as opportunities present themselves. Ultimately, creating the proper balance between risk and return through diversification takes careful decision making and important discussions between you and your Atlantic Trust relationship manager. Your objectives and amount of risk you are willing to tolerate to achieve them are at the heart of our philosophy as fiduciaries. We appreciate that volatility can foster anxiety, but in heightened periods of volatility, we believe adhering to a long-term strategy and maintaining a disciplined investment approach are essential aspects to investment success. n www.atlantictrust.com Page 5 Understanding Market Volatility
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