Wednesday, December 19, 2012

“Investors have few spare tires left…”

“Think of an image of a car on a bumpy road to an uncertain destination that has already used up its spare tire. The cash reserves of people have been eaten up by the recent market volatility.”... Mohamed El Erian, CEO of PIMCO

We always hear the word volatility used in the media, by financial advisors and planners like me, but what does it really mean to you as an investor in dollars and cents? Sometimes a picture is worth a thousand words.

                       Low Volatility                                             High Volatility
                            Plan A                                                             Plan B
Year       Growth of $100,000    Annual Rtn.    Growth of $100,000     Annual Rtn.
1                    $110,000                             10.0%                     $134,000                       34.0%
2                    $115,500                               5.0%                     $121,940                        -9.0%
3                    $131,670                             14.0%                     $153,644                       26.0%
4                    $143,520                               9.0%                     $129,061                      -16.0%
5                    $162,178                             13.0%                     $169,070                       31.0%
6                    $165,421                               2.0%                     $167,380                        -1.0%
7                    $185,272                             12.0%                     $197,508                       18.0%
8                    $214,916                             16.0%                     $173,807                      -12.0%
9                    $227,811                               6.0%                     $210,306                       21.0%
10                  $257,426                             13.0%                     $227,313                         8.0%
                      Average Return                 10.0%                                                             10.0%
                      Compound Return              9.9%                                                               8.5%
                      Standard Deviation           4.5%                                                           18.6%           
Hypothetical portfolios for illustrative purposes only. Diversification does not assure a profit or protect against a loss.

This illustration looks at a low volatility vs. a high volatility portfolio.

The average rate of return is the same but the end result show that a lower standard deviation portfolio can compound at a higher rate of return and create more wealth over time. The longer the time period, the more pronounced the end result will be.

Most of the advertising done by investment companies show the average rate of return and may not explain the underlying volatility.

Here is another important point. A portfolio that goes down 50% requires 100% appreciation to get back to even.

In comparison, a portfolio that is down 8% only requires a recovery of about 9% to get back to even.

The greater the loss, the smaller the base on which your earnings can compound.

Yr     Growth of $100,000     Annual Return        Growth of $100,000     Annual Return
1                   $50,000                         -50.0%                                   $92,000                       -8.0%
2                   $54,500                           9.0%                                  $100,000                        9.0%

You can see from this example it would take years to get back to the original investment.

If you or your spouse is handling your own investments, make sure you both understand the risks you are taking on with your investment strategies.

If you don’t understand, or are unsure how to measure your portfolio’s risk, you may benefit from getting a second opinion or evaluation. The money spent with a professional could save you thousands of dollars in the future.

Knowledge is the power and you should understand the “whys” of how each investment made its way into your portfolio and the “how” of how this investment will help you meet your long term investment goals.

Securities and Investment Advisory Services offered through NFP Securities, Inc., Member FINRA/SIPC. NFP Securities, Inc. is not affiliated with Fish and Associates.