Ever think, or even utter out loud for that matter, "This market is killing me!"? Most of us have at one time or another in the last couple of years. While said in jest (I hope), there is more truth to this than perhaps one would expect. We live in a new world of extremely volatile markets and our investment choices need to address this change. Here’s why, if you look at two hypothetical portfolios with similar average returns, the portfolio with lower volatility will be the one that almost always outperforms. Let’s look at a specific example. Assume each portfolio starts with $100,000 at the beginning of year one. The percent return and dollar values are calculated as of year end.  Note that in spite of having a lower average annual return, Portfolio B produced a much better real return and Portfolio A had actually lost money at the end of five years.

                        PORTFOLIO A                         PORTFOLIO B

Year             % Return      $ Value                % Return       $ Value

    0                                  100,000                                    100,000

    1                  +50           150,000                    +25          125,000

    2                  - 40             90,000                    - 20          100,000

    3                  +30           117,000                    +15          115,000

    4                  - 25             87,750                   -12.5         100,625

    5                  +10             96,525                     + 5          105,656

Average Annual Return:        + 5.0%                            + 2.5%

Actual Total Return:              - 3.5%                            + 5.7%

What’s going on here? How can a portfolio that has half the average annual return end up with a higher ending balance, especially when they were both up three years out of five? The answer is volatility. The harsh reality of how the math works greatly penalizes high volatility portfolios in down markets. Here’s a simple illustration. If you loose 50% of portfolio value in the first year it takes a whopping 100% return the following year to make up the loss. The downward percent penalty is so great that even when we started portfolio A in the above example with an up 50% first year, it still lost money after 5 years. High volatility can kill investment performance.

There are two points to be made here. First is the obvious one, portfolios that underperform in the up years but avoid big losses in the down years are destined to outperform over time. Perhaps more importantly, when judging a manager’s performance, don’t get glassy eyed over big positive returns. Be very critical of the magnitude of the down years because they can be the deciders of the real performance. Ask yourself, if I had put $100,000 in this portfolio 5 years ago would I have really made money? When in doubt do the math, it’s easy.

So how do we avoid excess volatility? For smaller portfolios it’s a matter of choosing your fund carefully. Look at the long-term returns and focus less on the highs and more on the consistency of returns. For larger portfolios, carefully search in each category for funds or managers that perform consistently well with the least relative volatility. A fund with five stars from Morningstar but with a history of years with large negative returns probably ought not be your first choice. Also, limit your weighting in more volatile sectors so they won’t drag down your performance so much in down years.

Short of buying a CD or Treasury Bills, you can’t avoid all volatility but you do want to try to keep it under control. Your portfolios will thank you for it.

We’d like to take this opportunity to wish all our clients and friends a very happy and healthy holiday season.

Randy Gridley

December, 2002