The Investment Scientist

A costly investment mistake: confusing volatility with risk

Posted on: April 23, 2008

Confusing volatility and risk could cost you a bundle. Let’s take a look at returns on an investment of $1000 over 50 years from 1958-2007 in five asset classes.

  • Small cap value: $3,750,000
  • Small cap growth: $81,200
  • Large cap value: $854,000
  • Large cap growth: $130,000
  • CD: $13,800

Isn’t it obvious which is the best long-term investment?

Why small cap value is the best long-term investment

So you don’t have a 50-year investment horizon? Few of us do. How about a ten-year horizon? In any ten-year period from 1958 to 2007, small cap value had much better investment results than a “safe” CD. (See Table below. Green = best result in the given ten years; red = worst.)

Table: How would $1 investment become?

    10 year periods Small Cap Growth Small Cap Value Large Cap Growth Large Cap Value CD
    1958-1967 $5.64 $8.02 $3.22 $5.39 $1.36
    1968-1977 $0.97 $2.66 $1.2 $2.64 $1.75
    1978-1987 $3.38 $7.84 $3.52 $4.96 $2.41
    1988-1997 $2.87 $6.47 $5.38 $5.13 $1.7
    1998-2007 $1.53 $3.47 $1.77 $2.36 $1.42
    Annual volatility 28.23% 24.05% 17.67% 18.54% 1.7%

Safety paradox

Even though a FDIC guaranteed CD is perceived to be safe, over time, inflation eats away at returns. For the long-term investor – and by that we mean you – small cap value is less risky.

Why do few investors put their long-term investment in small cap value? And, when the going gets rough, why do many small-cap-value investors switch their money to CDs?

Here’s why, small cap value is highly volatile (See last row of Table) and volatility makes us anxious and jumbles our judgments.

Volatility does not measure risk.” -Warren Buffet

Volatility becomes risk only when the investor can’t stand it anymore, and abandons an otherwise safe long-term investment. Typically, volatility is highest and its impact most painful when the market reaches bottom. Not surprisingly, many investors bail out at the worst possible time.

Upon learning that he had to sail by the Sirens – the creatures whose beautiful songs could lure him to jump to his death – Odysseus asked his sailors to tie him to a mast. What mast do you tie yourself to?

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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