Winning the mental battle against volatility – the ostrich method

I’m planning to write a few entries on a topic close to my heart (insert jokes about how I need a real life here): portfolio volatility.  To begin, let me propose an old-fashioned technique for fighting the mental anguish associated with market volatility: the ostrich method.

A keen user of the ostrich method.  Source: Google Images.

A keen user of the ostrich method. Source: Google Images.

Let me explain with a concrete example:

  • A somewhat-typical portfolio: 
    • 50% long equities.  Proxied by the S&P 500 index
    • 30% long bonds.  Proxied by the performance of a US Treasury Bond ETF
    • 20% long commodities.  Proxied by the performance of DB Commodities ETF
    • Portfolio start = Feb 2006 (start date of commodities ETF)
    • No rebalancing.  Just set and forget

Let’s look at the data.  All return series are rescaled to begin at 100:

Portfolio performance view Feb 2006 - Nov 2014.  Source: Quandl

Portfolio performance view Feb 2006 – Nov 2014. Source: Quandl

A couple observations:

  1. Nice performance.  What we all know by this point: buy and hold (if you kept through the crash of 2008) worked just fine.
  2. Lots of squiggles.  That’s volatility for you.  Not just the big swings (e.g. portfolio value going from 120 -> 80 in the crash), but the regular gyrations in the market.  Look at the recent sell-off in equities at the right edge: that was indeed cringe-worthy.
  3. (aside) Long commodities don’t look very good.  I’ve talked about this at length in previous posts.

Now for the ostrich method of combating market volatility.  It’s simple to explain, by devilishly difficult to enact:

  • Overall theory: returns for market risk premia generally oscillate, but are positive in the long term.  Thus, if we censor intermediate observations, we can focus more on the long-term drift than the interim fluctuations.
  • In plain speak: markets rise and fall a lot, but generally rise over time.  For long-term investors, it makes sense to generally ignore market prices until a decision needs to be made (e.g. rebalance or sell holdings).
  • Example: Using the same portfolio shown above, let’s take a look at a couple more charts.
    • Monthly looks: suppose you just look at your monthly brokerage statement, and forget about financial headlines/news.  Here’s how your portfolio growth would look.  As an aside, look how the recent equity sell off has “disappeared” from the chart…
    • Same portfolio, using monthly data.  Source: Quandl.

      Same portfolio, using monthly data. Source: Quandl.

    • Yearly looks: suppose you just look at your annual review of your account.  Here’s how the portfolio growth would look.  Notice how smooth everything looks!
    • Same portfolio, using yearly close data.  Source: Quandl.

      Same portfolio, using yearly close data. Source: Quandl.

In sum, and probably flogging a dead horse here: long-term investors shouldn’t care about the newspapers/financial news/websites/etc., at least insofar as making portfolio adjustments.  Diversification works, when given time.

Next time I’ll write how volatility is a very useful thing.  Sometimes we might want more, not less, volatility in our portfolios.

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