Why would long-term investor care about volatility?

Question

I'm 35 and I want to start investing for my retirement. My question is, why would you care about volatility if your investment horizon is 30+ years? In order to get a more clear picture of volatility risk, I gathered some data in Python and computed portfolios with varying percentages of risk-free bonds, with a buy and hold of 100k USD initial:

Looking at the graphs, the only reason I could think of is that when you need your money in times of bearish markets, you can lose 30-40% of your capital. But if you can miss the money, and won't need to withdraw it early, why would one care about volatility?

Edit Someone requested to see what would happen if you invested on the peak just before the 2008 crash.

As you can see the timing would have meant five years of a negative balance, before you broke even again.

Proposing another angle to the question, without having done the analysis myself: what happens to the above chart if you are dollar cost averaging, i.e. investing a sum every so often into the markets rather than buying a fixed amount on day 1 and holding? The former is probably a more realistic assumption. — Doggie52, Nov 08 '21 at 17:19
Just to give you some perspective about comparing the past with the future and what volatility really means, do the same with the Nikkei225 over different 30 year periods. Not saying investing is bad, but your analysis is based on an "always up in the long run" theory. The question is, how long is long in the future? And how long can you hold if, for example, you get hit by a bus tomorrow and can't work anymore? Volatility = risk. Risk = potentially more gain. More or less at least. — DonQuiKong, Nov 08 '21 at 17:26
It would be interesting to repeat your analysis with a few different start dates. What happens if you invest at the pre-2008 peak, or in the 2009 trough? I think volatile stocks are more susceptible to lucky or unlucky timing. Both when buying now and selling in the distant future. If you dollar cost average like @Doggie52 suggests, my understanding is that volatility should wash out. — craq, Nov 09 '21 at 01:59
FYI it was probably unnecessary to use Python to interpolate between two curves. Unless there's some periodic rebalancing or something, you're just showing which curve is higher. — user253751, Nov 09 '21 at 19:00
@user253751 It was part of an analysis that I'm doing. I also have a part where I keep investing and rebalancing. Do you think those graphs would look different that I simple buy and hold with an initial investment? — Mark, Nov 09 '21 at 19:54
@Mark Yes, I think those graphs could look different. I'm just pointing out that the graphs for buying and holding different combinations of stocks and bonds, are simple linear interpolations of buying and holding only stocks, and buying and holding only bonds. There is no possibility that something in the middle performs better than both extremes. — user253751, Nov 09 '21 at 20:34
@user253751 the graphs are meant to show how fixed income decreases volatility and return, I wasn't expecting differences in performance — Mark, Nov 09 '21 at 20:51

score 30 · Accepted Answer · answered Nov 08 '21 at 09:22

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If you really do not need to withdraw the money, it is just for psychological reasons. Excessive volatility makes many people uneasy and probably rightfully so given the amount of money involved after a few years of saving.

However, there is a caveat to this. At some point you will need to withdraw money and high volatility will increase the risk that you cannot withdraw money at a good price. This is why it is recommended to reduce the allocation to risky assets as one approaches retirement

answered Nov 08 '21 at 09:22

Manziel

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Thank you for your answer! So as long as you have a savings amount that would satisfy any contingency/emergency that arises, you're good? Is there some kind of rule on how much savings you should have, like half, one, or two times your yearly salary? – Mark Nov 08 '21 at 15:19
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There is no general answer to this. It strongly depends on your liabilities (e.g. mortgage), your general cost of living, unemployment benefits of your country and how easy it is to find a new job in your field. Keep in mind that there can always be nasty surprises. For example, who would have thought that many pilots will be out of work for such a long time? – Manziel Nov 08 '21 at 15:57
Haha good point about the pilots. I was doubting starting pilot school when I was younger, but decided not to go for it. You would have a 130k debt after finishing, but is was "going to be worth it". A couple of years later price fighter airlines started arising, pilots got the bad end of the deal.. – Mark Nov 08 '21 at 16:34
@Mark You should be saving roughly at least 30% of your monthly income after income taxes but that 30% includes non-rental house payments and social security contributions. Ideally, three to six months of income of your savings should be in low risk assets such as money market funds or short-term bank deposits for emergencies, lay-offs, etc. – Alper Nov 08 '21 at 18:46
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Also, securities don't just acquire high volatility (vs the market average) for no reason - they're volatile because there is a significant spread in investor confidence in the instrument. If you're holding for the long term, high volatility can indicate a security that may not have long-term prospects. It may be a safe hold for the next year or two, but it may be a dead sinker on a 10-20 year timescale. When you're investing for the long term you're looking for solid fundamentals, and those rarely come with high volatility. – J... Nov 08 '21 at 21:09
@Mark Consider the first graph. Ideally, if you were in retirement, you would not want to sell any e.g.: S&P500 funds during a 4 year period (perhaps longer even.) So the idea is to hold enough cash and stable investments to be able to weather such storms. How many years you plan to be able to manage like that is a personal choice. – JimmyJames Nov 08 '21 at 21:35
Also note that high volatility can also increase the chance at withdrawing money at a great price. The volatility works both ways. – Gregory Currie Nov 09 '21 at 01:39
Agree with the answer. But what about after retirement? Prof. Wade Pfau has proposed that retirees INCREASE their stock allocation gradually, after retiring. "Michael Kitces and Wade Pfau found that a rising equity glide path, particularly one starting with 30% in equities and increasing to 70% over a 30-year period, yields better retirement outcomes" I.e. gradually reduce equities to 30% of your portfolio as you approach your retirement date, then gradually increase equities again through your retirement years. https://www.thebalance.com/what-is-an-equity-glide-path-2388560 – Orange Coast- reinstate Monica Nov 10 '21 at 17:13
Do you have a primary source for that? This definitely goes against conventional wisdom and against simple common sense. While I agree that a substantial portion of assets (like 40%) should remain in equity to keep participating in their high returns, I can't imagine a good (and universally applicable) explanation why increasing the equity allocation is better. Once in the withdrawal phase, high returns are secondary and avoiding default is the primary goal. – Manziel Nov 11 '21 at 07:37
One should also be aware that in investment research many findings tend to be overfitted to certain time periods. Returns for various asset classes differ considerably over time. Change the average bond return from 5% to 0% (or even negative) as we see it right now...and the original 4% rule probably will not work – Manziel Nov 11 '21 at 07:40

score 4 · Answer 2 · answered Nov 08 '21 at 22:48

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At age 35, a 100% stock allocation makes intuitive sense, because as you mentioned, you have the time to ride out volatility.

At age 20, a 200% (levered) allocation could make sense: Lifecycle Investing

To simulate retirement scenarios, finance professors use Monte Carlo analysis. A piece of commercial software based on academic research is MaxiFi.

To encourage individual investors to ignore volatility, Bogleheads (advocates of low-cost investing) adopt a Lazy Portfolio.

answered Nov 08 '21 at 22:48

Orange Coast- reinstate Monica

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There is still a big gap between '100% stock allocation' and 'ignore volatility'. Investing in bitcoin or something similar was over the last 10 or 20 years more volatile and more profitable than any stock allocation. If you completely ignore volatility that would suffice to make 100% bitcoin an ideal investment for the next 30 years. I don't think that would be a wise idea. – quarague Nov 09 '21 at 11:01
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@quarague Apples and Oranges. There's a difference between investing and speculation. Investing (stocks) has an expected rate of return (average growth), and volatility is the noise on top of that average growth. Bitcoin is a speculation, and by definition, does not have any expected rate of return. If you hold SPY (per OP) for 30 years, you would expect to have some X% more at the end of that period, regardless of the path it took to get there. In 30 years, how much will you have in bitcoin? What long term, historical precedence do you have to stand on? – dberm22 Nov 09 '21 at 15:00
@dberm22 isn't the high expected rate of return on stocks just based on historical performance i.e. volatility (if it turns out we are in a massive random up-cycle)? – user253751 Nov 09 '21 at 17:26
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@user253751 The rate of return of stocks has many drivers that should withstand the test of time. While you shouldn't hang your hat on historical performance dictating the future, certain factors that will likely not changes are: efficiency increasing over time, inflation increasing the price of goods that the companies sell, more people equals larger demand, etc. Maybe those factors slow moving forward, but they are still expected to increase the value of the overall stock market over long periods of time. – dberm22 Nov 09 '21 at 18:45
@dberm22 however, those factors don't seem to have impacted the Nikkei and to a lesser extent the EURO STOXX – user253751 Nov 09 '21 at 18:56
A couple of points on this: European equities are valuable for diversification if for nothing else. In the 2000s they outperformed US stocks and in the 2010s they underperformed US stocks. 2nd point that would outrage finance professors: Buffett and Munger avoid certain countries as "not capitalist enough." They avoided Japan for 45 years until very recently, when they said that the major trading houses in Japan had adopted shareholder-friendly capital allocation policies. This Buffett/Munger policy would also apply to France and possible Germany: Too shareholder-unfriendly to invest. – Orange Coast- reinstate Monica Nov 10 '21 at 17:02
@user253751 I knew someone would bring up Nikkei. For that reason, I was very careful to say "should withstand", and "likely not change". I should have just faced that comment head on from the beginning. – dberm22 Nov 10 '21 at 18:22

score 2 · Answer 3 · answered Nov 09 '21 at 08:17

People care about risk, and volatility is part of that. Just because in the past volatility could be "ignored" or "has averaged out" over a timespan of 30 years (say), this does not mean that it is guaranteed to remain true in the future. For example, there could be a long series of crahes caused by some unfortunate chain of global crises, or in 2045 betting on volatility suddenly becomes such a thing as betting on GameStop, cryptocurrency, you name it...

Why would long-term investor care about volatility?

3 Answers3