Risk Realized & the Goal Window

When the wiggle becomes risk

Risk continued

Over the past month or so, I’ve published two other articles exploring the idea of risk. In the first article of the series, we spent time thinking about the idea of risk and how it feels. We also talked about two of the most common feelings and biases associated with risk, risk tolerance and loss aversion. In the next article, we thought about risk in a more practical way. We saw how risk plays out over the duration of our investments and we were introduced to the idea of volatility, or what I affectionately call “the wiggle”.

Today I would like to talk more about the relationship between the wiggle and risk. That is, when one turns into the other. Even though these ideas are related (and can feel identical day to day), they are really only tangentially related. That is, even though we talk about them in the same way, they never really exist at the same time in practice. Let’s dive in.

The wiggle revisited

As I mentioned, the last article I wrote dealt with the idea of volatility. We saw how investment returns rarely take a straight path from buy to sell; along the way there are peaks and valleys, bubbles and swoons. We know the values of these investments will increase and decrease day to day, but the hope is we get some expected return over the long run. Why is this expected return important? Because the return is usually aligned with some important goal we have set for ourselves. Some amount of money needed at some point in time in the future so that we can finally retire or send our kids to college. These goals, and the related return, are what we structure the investment plan around to begin with.

Feelings revisited

While we have the end goal in mind, those ups and downs along the way can be stressful. As I mentioned, since our hopes and dreams are commonly attached to these investments, it can be difficult to watch the wild ride play out from day to day. When viewed on a daily basis, these investments can feel more like playing the lottery instead of a wisely planned investment strategy. These swells and drawdowns can drive us crazy and tempt us to make changes or sell the whole thing to avoid losses. Many people give in to these feelings and, statistically speaking, most all of them end up loosing in the long run.

The big picture

Making decisions based on short term changes can be disastrous to our long term financial goals. In my article on passive investing, I talked about how trying to navigate short term volatility is like trying to pick the “correct lane” in rush hour traffic. Since we rarely know the cumulative reasoning behind market movements, or likewise why traffic isn’t moving, it’s impossible to know the exact moment to change lanes or shift investments. Making those decisions in an effort to “get ahead” will only cause us to slide further away from our destination. Rather, the only time we should consider these moves is when our goals change (or we need to take the next exit).

Simply put, your investment decisions should not be based on this short term volatility. You investments should be chosen and held with the long term objective in mind.

Does volatility matter at all?

So if volatility should be largely ignored, does it ever matter? Despite everything I have said up to this point, the answer is yes. Volatility matters in three main ways: dollar cost averaging, portfolio rebalancing, and when you ultimately decide to sell your investments. For today, we will focus on the third reason. More to follow on the other two.

Return to the wiggle:

Remember this graphic from the previous article?

In this image we see a somewhat simplified version of investment return. There is the straight line representing the overall return rising towards a goal in the future. The squiggly line, the “wiggle”, represents the actual movement of investments as they rise towards the intended goal. If you recall, the higher expected return, the more wiggle (the more volatility) we should expect.

As I mentioned, along the way to our goal, this volatility doesn’t matter much. As long as you’re in the right investments to begin with, your goals don’t change. And since your goals remain the same, the ups and downs experienced while holding this investment shouldn’t matter. The wiggle is just the ride along the way.

Now let’s see when the wiggle does matter:

When volatility becomes risk

Imagine we time our goal perfectly. Also, imagine we selected the perfect investment to match our goal. It would look something like this:

Due to the timing of our goal relative to the short term volatility, it worked out perfect. The expected return and actual return (represented by the blue line) end up being identical.

Now, imagine we selected the same investment, but our goal timeline shifted somewhat. Same investment, same goal, but a shorter timeline. What happens to the return?

Here we see our previous expected return (gray line) doesn’t matter anymore. This is because, once we sell the investment, the return is realized. It becomes real. While the volatility didn’t matter much throughout the life of the investment, it becomes very important at the moment we decide to sell. As it turns out, we were pretty fortunate here.

But instead, now let’s move the goal a little later in our timeline:

As I’m sure you guessed, this can go both ways. Even though we expect investments to rise over time, here we see how moving a goal further in the future can actually hurt our returns. In this scenario, we have fallen short of our goal due to where the volatility was when we decided to sell.

No crystal ball

It’s easy to look at the examples above and pick the one with the shorter timeframe and higher overall return. It’s easy because we have all the information available to us. The hard truth is, no one can see into the future. What if you were the investor in that scenario? You are a few years from your goal and you note that your returns are way up. Would you consider selling in order to capture that higher return? Remember… you can’t see the downturn coming. You might sell, but most likely you would want to hold on and see how high it can go before you need to sell. Then it stalls. Then it starts falling. You hold because you’re still above your expected return and it might go higher again. Then it continues falling. It falls below your expected return. Now you’re at the point in time you need to sell and you’re faced with difficult decisions.

The problem with specific goals

As mentioned, well formed goals typically identify a certain amount of money at a certain point in the future. I need $X by the time I’m 62 so I can retire. I need $X in five years so my son can go to (insert name here) college. Not only are these goals helpful in determining the amount of money needed to reach those goals, but they also help determine the associated return required. A specific goal looks like this:

While this goal seems very clear and specific, we’ve seen above that it’s nearly impossible to know what kind of volatility we should expect when the time comes to realize our goal. This becomes a greater problem when we need higher returns because, as we’ve learned, higher required returns means more volatility. You guessed it: more volatility means a greater risk of falling short of your goals.

The goal window

Since a specific goal might cause some harm, what if we allowed ourselves some margin on either side?

In the figure above, let’s define the terms. Let’s say the specific goal is “retire at age 62 with $1,200,000 saved for retirement”. Fair enough right? But what if your 62nd birthday arrives and a sudden 20% drop in the market means you’re looking at a balance of $960,000 in your account? What if a sudden run up in the market meant you reached your $1,200,000 goal a year early?

This is where a goal window can help. Instead of stating “retire at 62”, we can say “retire sometime between 61-65 with $1,200,000”. As long as you’re OK retiring a year early or delaying a few years, this allows you a little leeway to hit your target. Also, I should add, a goal window allows you to accept a little more volatility than you otherwise might. And, you guessed it, that allows for the possibility of greater returns.

The goal window works vertically, too. If your timeline is firm you might want to accept a window of possibilities for your expected return. This would sound like “I’m retiring at 62 no matter what. I’ll make the money work”. In this scenario, the timeline is firm but we have a window of possible return outcomes. You might end up with $1,400,000 or $1,000,000, but you retire anyway. This type of investor is likely to value time and opportunity over a specific return or amount of money. Again, while this strategy isn’t for everyone, it allows for the acceptance of greater volatility and the possibility of greater returns overall.

The risk that matters

When we talk about investments, the only risk that matters is the risk of not achieving our goals. After all, our goals are the only reason we’re doing this to begin with. Yes, there is volatility along the way and there’s no way to predict what will happen next, but we should always focus on the long term goals. Keep the main thing the main thing, if you will. If you keep the long term in focus, choose reasonable goals along with associated investments, and allow yourself a window of success, you can accept more volatility overall and avoid the sting of true risk; the risk of losing out on your dreams.