A Brief Reminder About Volatility

| September 10, 2011 | 0 Comments

By Rick Brooks

When you are investing, you are being paid to take risk. The more risk you take, the more you should expect to make on your investments. This is something that seems to be forgotten during the good times. But volatility is part of investing. If you are not willing to take risks, and accept the possibility of losses, then you should not be investing your money; it should be in a savings account.

This month’s column is about risk and volatility. It is as natural and important to investing as breathing is to living. You’ve probably heard the phrase “nothing ventured, nothing gained” or “no risk, no reward”, or some other similar platitude. These are as appropriate to investments as they are to business or life in general.

There are few truly risk-free investments. Bank accounts and Certificates of Deposit are often considered risk-free, as are Treasury Bonds (well, by everyone except Standard & Poor’s, but that’s a different column). It wasn’t so long ago that you could earn a decent return in these risk-free investments, but not in today’s environment. There are so many people trying to preserve their savings and avoid risks that banks don’t have to pay any interest rate on your savings.

It’s important to remember: even CDs can carry some risk. When you shop for the highest yielding CDs, invariably you are taking on some (albeit small) additional risk. The market has determined that Bank A must pay a higher rate than Bank B for the same deposits, because of some risk factor related to Bank A. We saw a lot of this in 2007 and 2008 when Washington Mutual paid relatively high interest rates on their CDs. In hindsight, we now know why. At the time, it was the market’s way of telling us that something wasn’t right.

So once you decide that you want higher returns than the current ‘risk-free’ rates, whether it’s in corporate bonds, preferred stocks, common stocks or even gold, you must accept the fact that you are taking on greater risks to do so. With that greater risk comes volatility in the value of your investments, as well as the possibility you could lose money.

So what can investors expect? The simple answer is that the more you expect to earn on your investments, the more volatility you should expect in the value of your investment. Whether you see this volatility or not is a different question; you should expect it.

One very important thing to remember is that not all investments go up or down at the same time. This is the key to diversification. Generally speaking, bonds will lose value as interest rates rise. This most often occurs when the economy is strong and stocks are rising in value. Conversely, bonds often gain in value as interest rates fall or as investors flee the volatility of stocks for the ‘safety’ of bonds.

What most investors try to do, then, is combine assets which are relatively stable, such as core bond funds (investment grade corporate and government bonds) with their stock investments. The more stocks you have in your portfolio, the more volatility you can expect. Adding other investments like commodities, real estate and gold can diversify your portfolio somewhat, but each of these are highly volatile investments in their own right. The advantage, though, is that they may rise or fall at different times than “plain” stocks.

Here is where I have to say that a Certified Financial Planner® professional can help. They are trained to help you design a portfolio that will meet your return objectives with a volatility level that won’t push you off your plan. And at the end of the day, having a plan – an investment strategy – is one of the most important aspects to successfully managing your own portfolio.

This column is prepared by Rick Brooks, CFA, CFP®. Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Rick can be reached at (858) 755-5166, or by email at brooks@bfadvisers.com. Rick and his family live in Mission Hills.

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