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Investing Risk and Volatility Aren't the Same

David B. Armstrong
7. Stock market returns are Volatile. I have said this a billion times in my blog. Also the equity returns are superior to other asset classes because of volatility. However at the first signs of the markets jump up or fall down people start asking ‘what is happening in the market’. Hey nothing is happening – that is how the market behaves!!

Consider the elevator ride. I get in, press the button and wait to get to my floor. Some rides are slow if the car is full, some rides are smooth and sometimes I get on a down elevator when I want to go up. Eventually, though, I get where I am trying to go. Let's call it "elevator volatility."

One thing I don't consider on those rides is the the risk associated with riding elevators. The risk is there -- cables snap, emergency brakes fail -- but the various paths to my destination have nothing to do with the true measurement of the risk of equipment failure. There's a lesson here for investors.

Investors and financial services firms seem to assess risk and construct portfolios based on the volatility of the ride rather than its actual risks, even though an appropriate measurement of risk in investing, especially for long-term investors, is the failure to achieve a final outcome. Unfortunately, the industry is obsessed with the idea of volatility, especially short-term volatility.

Think about reacting to volatility for a minute. It's really an emotional barometer. Traders and investors buy and sell on reaction (and usually overreaction) to news and speculation without any consideration to long-term returns. Recall the sell-offs of 2011 and 2012 and look at where the markets are today. Volatility went through the roof, but did it really affect the long-term returns of an investor who assesses risk in terms of long-term failure to meet a final outcome? No. In fact, those who stayed invested while experiencing extreme volatility are probably better off for it.

Risk and volatility are not interchangeable, and trying to minimize volatility can actually hurt returns over time. The financial services industry is rife with advisers, compliance departments and research departments who embrace constructing portfolios with a serious allocation to bonds because they will lower volatility. Not only is it well proven that stocks outperform bonds over the long term, but at today's interest rates, the interest payments on bonds are having a hard time even outpacing inflation. So in the interest of reducing short-term volatility, portfolios are being constructed with investments that increase the probability of actually impeding long-term growth.

But it's an emotional issue too. Investors like the idea of seeing their portfolios grow without the wild swings that accompany equity investing. It's understandable, since most people look at their account balances on a very regular basis and they only like to see their accounts go up, not down.

It's a common refrain that investors say they'd be happy beating a broad stock index "with less risk on the downside" or some variation on that theme. The problem is any anyone telling you they can do that is either a charlatan or a fool.

But the financial services industry, including the sales side, the compliance side and the advisers who are not running their own money, have adopted volatility as a measure of risk anyway. They use it to justify portfolio creation, the manufacture of investment products and the rationalization of compliance oversight. It also feeds into the emotional needs of clients, which facilitates sales.

This is simply not in the best interest of clients. The industry has adopted the mindset that it's more important to concentrate on the ride rather than the destination. (This puts even the best advisers in a tough spot as well. They must choose whether or not to cater to the sentiments of a poorly conditioned client in order to not get fired.)

Here's a gauge - simply think about the last portfolio review you either received or conducted. Was it all about how well the portfolio did relative to an all-equity benchmark like the Standard & Poor's 500 index? This is a measurement of the near-term ride rather the ultimate success or failure of the portfolio.

What both investors and advisers can do is to reevaluate their portfolio construction and determine whether it has been designed to manage short-term volatility or avoid the risk of failure over a longer time horizon.

Like the elevator ride, don't focus on the ride to your floor, just focus on the destination. The real risk is in failure, not how smooth or quick the ride is. As for what to consider trimming from investments designed only to smooth the ride, take a hard look at the bonds you own. If you own them for income and plan to hold them until they mature, that's one thing, but if you have them because they are supposed to reduce volatility, it may be time to reconsider.

David B. Armstrong, CFA, is a Managing Director and Co-founder of Monument Wealth Management, a Registered Investment Advisor located just outside Washington, DC in Alexandria, Va. David is routinely featured in national media sources and has been a speaker at several major industry conferences including Barron's Winner's Circle, IMCA, InsideETFs, LPL Financial Business Leaders Forums and Focus conferences. Follow David on his blog which can be found on his website, on Twitter @MonumentWealth, and on the Monument Wealth Management Facebook page.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly.

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