As this tumultuous year has shown, the subject of risk is critical for investors to understand. Yet the usual ways advisors and financial experts define risk are lost on most clients. Standard deviation, Sharpe ratio, and R-squared are terms most clients don’t understand or don't know enough about to care about. To have a meaningful conversation about risk, advisors need to stay away from jargon and speak in terms that are easily relatable. We have found that one of the best ways to do that is to define risk by loss of capital.
To further explain this, the chart below shows the calendar year returns for the S&P 500® Index from 1999 to present, in gray, capturing the coming and going of several bull and bear markets. The green bars show the Index’s intra-year increase—the highest percentage rise experienced during the year. Likewise, the orange bars show the lowest return for the year. Clients should keep in mind that the high points are increases, not gains. They would only be gains if an investor sold at the high point and locked in their profits. Similarly, the low points are declines, not losses, unless you happened to sell at the market’s trough.
Seeing the Volatility Within the Annual Return
S&P 500® Calendar Year Total Returns (%) (1999-2020)
Source: FactSet, S&P Dow Jones Indices. Data calculated from December 31, 1998-June 30, 2020 using total return. The indices are unmanaged, are not available for investment, and do not incur expenses. Click here for index definitions. Past performance is no guarantee of future results.
Using a visual like the chart above with clients can help make the concept of risk more intuitive and easier to grasp than looking at numbers on a page. The chart makes clear that volatility is a natural part of stock market investing and should not only be expected, but planned for. The year 2009 underscores why that is. In that year, the S&P 500 returned a robust 26.5%, but embedded within that performance was a whipsaw of returns, with a high point of 69.7%, and a low point of -27.2%. How would your client feel after seeing their portfolio’s value drop by a third? What would that mean to them in dollar terms? Highlighting potential dollar losses may help drive home your point about the need to manage risk.
Diversification in Action
Diversified Portfolio Calendar Year Total Returns (%) (1999-2020)
Source: Factset. For more detail on the diversified portfolio allocation please refer to the end notes. The indices are unmanaged, are not available for investment, and do not incur expenses. Click here for representative indices and definitions
By comparing the first chart with a similar bar graph for a diversified portfolio (the chart above), a few additional points can be made. Over the same time period, the average annual return of the diversified portfolio was 7.3%—slightly less than the 8.3% generated by the S&P 500 Index. Yet the Index’s average intra-year decline was -15.2%—significantly worse than the average low point of -8.5% for the diversified portfolio.
Looking again at 2009 as an example, the diversified portfolio had a less impressive high point (46.6% vs. 69.7%), but also a low point of only -17%, a full 10% better than the lowest point for the Index. Similar average returns over time with less risk—that’s the goal of diversification. We hope using tools like these two charts can help clients better understand these critical concepts.
For more ideas on coaching clients through volatile times, visit our Resource Center below.
Diversified Portfolio Allocation: Investment Grade Bonds (IG Bonds): 32%, Municipals (Munis): 5%, U.S. High Yield Bonds (US HYB): 5%, U.S. Large Cap Equity: (US LC): 23%, U.S. Small Cap Equity (US SC): 10%, Foreign Developed Equity (For Dev): 10%, International Small Cap (Intl SC): 5%, Emerging Markets (EM): 5%, U.S. Real Estate (REITs): 5%.