These are excerpts from a lengthy article by Dennis Gibb. I would venture a guess that more than half of our time at Snider Advisors is spent with clients helping them understand the difference between volatility and capital risk.
“Volatility is a risk only because both the financial advisor and the client may not be able, from a behavioral standpoint, to accept a wide variance in value without reacting badly. Volatility is really a name for a behavioral reaction to a normal market movement.”
“To use standard deviation as your measure of risk, you have to assume that at the end of the measurement period, the investment will be liquidated. That, of course, is nonsense. Standard deviation can only morph to a capital risk if we make short-term assumptions about the markets.”
“So what is the real risk clients and advisors should be concerned with controlling?
The answer is capital risk, the possibility that you will lose the money you invest. This is the risk that most people are intrinsically concerned about. It is a risk that is particularly heightened as people near retirement and face an attenuated lifestyle.
Why capital risk is more important than volatility
Income is produced by capital. Regardless if it is investment income, dividend income, or salary, it ultimately comes from capital. There is about 20 times as much capital in the economy as there is income. Lower tax rates encourage capital to move, where it can then be taxed. Highly taxed capital stays static. Tangentially, this is why every time tax rates are cut, government revenue rises.
To those in retirement, capital risk is a vital factor. Lost capital is irreplaceable, and once gone, it cannot produce income. Given the definition of the two risks, they would seem to be easily distinguishable, but in fact they are confused by many.”
“But since variance is quoted as a plus-or-minus number, if an investment is down, it also has the probability of going up. Therefore, the only risk to income in variance is if the investment has to be sold at a point in time or if the client's spending plan is calculated as a percentage of the portfolio value rather than the income produced.
The only thing that can permanently affect the ability of a portfolio to produce income is permanent loss of capital—in other words, capital risk. So by focusing on variance, particularly variance established historically, we are focusing on the wrong risk.”
“Securities analysts have demonstrated they are shills, and the financial news has proven itself an adjunct of the world's oldest profession.
What is called for is hard-eyed analysis, a willingness to stand alone, and knowledge of what you are selling. In reality, advisors sell only two things: our collective knowledge and our time. Right now both are very valuable.”
Source: Gibb, D. (2008, September). Capital Risk vs. Volatility-Where's the Real Danger? . HorseMouth.com. Retrieved from http://www.horsesmouth.com/hm.asp?ID=82056&Loc=&r=0%2E5418054.
Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method® are subject to risk, including possible loss of principal.