Is volatility the best measure of portfolio risk?

Portfolio balances in target date mutual funds generate far more volatility on the up side than on the down.

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Before you answer yes, consider the findings of recent research revealing that portfolio balances in target date mutual funds generate far more volatility on the up side than on the down.
We prefer to conceptualize risk in terms of probability. What is the likelihood that your client will retire with $1 million? What is the likelihood that the client’s retirement portfolio will be depleted if you use one asset allocation model and not another?
The rising popularity of life cycle and target date mutual funds demands re-evaluating how we perceive risk. If, for example, Sally is 35 years old, employed, with no sizable assets, and wants to retire at age 65 with $1 million, then Sally must entertain numerous options concerning what to do with her investments.
We performed computer simulations in which the hypothetical Sally invested in various portfolios, ranging from different types of life cycle funds to simpler asset allocations such as equity/bond mixes of 90/10 and 80/20. Our results, published in the fall issue of the Financial Services Review, revealed that portfolios with higher equity allocations generate higher levels of volatility than conservative portfolios.
Nevertheless, even simple asset allocation models with high proportions of equity achieve higher probabilities of meeting — and even surpassing — target goals than target date funds. In Sally’s case, an 80/20 equity/bond allocation, even with its volatile roller coaster ride, is more likely to get Sally to her desired goal than the smooth, balanced ride of a life cycle fund or a more conservative 60/40 allocation.
Does this mean that target date investments are bad? No, but they may be understating the risk associated with not reaching one’s portfolio goals, even if their simple “autopilot” nature provides the psychological peace of mind that high-equity portfolios don’t. In that case, the risk of achieving smaller portfolio balances is offset by the absence of anxiety related to watching one’s investments ride the market roller coaster.
Risk entails both the likelihood of getting to an end point, such as retiring a millionaire, and the means by which one gets to that point.
The ride to retirement, therefore, is replete with two kinds of risk — the likelihood that on any one day, the stock and bond markets will fluctuate and the likelihood that at the end of the roller coaster ride, the investor may find himself or herself unsuccessful in reaching the desired financial goal.
What, then, does volatility look like? Investing in the stock market is like climbing a rugged mountain trail with the summit as the goal. The trail has its ups and downs on the way to the top, but history shows that the uphill slopes ascend more than the downhill slopes decline.
From 1926 to 2006, for example, returns on the Standard & Poor’s 500 stock index exceeded 15% in 39 years. Only six times did the S&P 500 decline more than 14%. Large gains, therefore, were 6.5 times more likely than large losses. The remaining 42 years were evenly split between gains and losses.
No doubt the stock market is volatile, but the distribution of portfolio values is asymmetric toward high outcomes. If history repeats itself, then volatility represents upside risk, not downside risk.
We propose that advisers think of risk not merely in terms of a roller coaster but in terms of probabilities associated with achieving, or failing to achieve, specific dollar amounts.
We contend that framing risk for clients in terms of dollar amounts, whether specific target portfolio amounts or specific target withdrawal amounts once the client is retired, is superior to focusing on volatility alone. First, such a metric is easily comprehended.
“If you want to become a millionaire, how willing are you to invest in the ways necessary to become a millionaire?” That’s a question you can ask Sally once you explain the ups and downs of the path. No doubt she will have to determine the strength of her desire to become a millionaire against her comfort with the volatility that may be necessary to reach her goal.
Second, framing risk in terms of dollar amounts does not ignore or eliminate standard deviations, betas and other measures of volatility. To the contrary, it places those measures in the proper context of an ever-changing market.
By replacing the confusion of statistical measures of the risk/ return trade-off with the chances of reaching specific dollar amounts, the investor can more clearly establish risk preferences and comfort levels.
Robert M. Eisinger is an associate professor of political science, and Harold J. Schleef is an associate professor of economics, at Lewis and Clark College in Portland, Ore.