In an article by Dan Richards, “The True Cost of Volatility,” he explores what volatility means (and costs) in a practical sense. If one looks at the growth of a highly volatile asset class, one will see remarkable growth of wealth. There will be lots of ups and downs, but over the long-term, the asset class will show an overwhelmingly positive end result. One might then surmise that making that asset class a larger part of a portfolio is a smart move. Unfortunately, the volatile ups and downs are often overshadowed by that elusive ending value that displays a significant total return over a long time-period. The problem is that volatility is real, and tolerance to downward market swings is thin-skinned.

A study by Morningstar, looking at 10-year annualized returns (ending 2007), that accounts for cash flows in and out of funds, found some interesting numbers.

An investor that held a specific sector fund did worse than the actual fund. How’s that possible? It has to do with the investor not being able to stomach the volatility. In balanced funds, investors captured all of the actual performance of the fund. The reason for this is that the balanced fund produced smoother returns that investors could swallow more easily for the full time-period. With the balanced funds, investors tended not to flee when returns were sub-par. One can see that an annualized 1.13% was given up due to investors’ distaste for higher risk. For all intents and purposes, we could look at this as an explicit opportunity cost associated with investing in specific sector funds for the time period researched.

Morningstar then looked at funds based purely on standard deviation, as opposed to sector funds versus balanced funds. A similar pattern to the above table was uncovered.

A couple of valuable takeaways result from this article. First, discipline and diversification are critical to successful investing. Second, risk can be increased beyond a tolerable state; at which point, more harm than good is often the result. Having a well-constructed portfolio means having a palatable portfolio that is naturally diversified, where the risk is just right, unforced errors are mitigated, and discipline requires little action.

The full article is here.