Volatility Explained: Understanding Investment Fluctuations

They're going to come to you and say , gee , I want an investment that's going to double every five years and I don't want to worry about it . It must just go up and up . And usually the first question I'll ask them after that is that's fine , no problem . When would you like me to message you when your money's down by a third or by half ?

And usually they'll stop and they'll look at me as if I'm insane or smoking something and ask me why I'm saying that . And so I'll say to them that's fine If you want something to double every five years , that's not unreasonable , it's not a guarantee .

But , gee , that comes with a thing called volatility , it comes with investments going up or down , and I just need to know when are you going to become uncomfortable ? And to me that's not risk , that's something else .

So to get into the topic , I'm thrilled to have a now repeat guest , chris Rule , who's head of solutions at 10X Investments , not head of investments . Thanks so much for joining us , chris . Thank you , warren . Thanks for having me again . So , chris , I think let's just start .

I don't want to get into kind of a textbook discussion , but I do think we should just kind of break out the difference between this thing called volatility and then risk , and maybe I mean , I don't know if you want to knock out volatility first , or should we get into risk first .

Like you say , it's how much things go up and down . So volatility is a measure of risk . It's because something that goes up and down more attaches more risk . Let's take cash , for example . We don't expect it to go up and down at all .

Right , cash at the bank should stay flat and that's the least risky or the risk-free investment , in a sense , is really cash as an investment . So the volatility of cash is zero and so it has no risk in that sense attached to it . And we'll talk about the different facets of risk .

But something that has a volatility of , say , 15% and we measure it , if we're going to go a bit textbookish , by something called standard deviation , basically just means that there's a high probability . If your standard deviation , let's say , is 15% Equities , let's say shares and stocks the volatility of a basket of those is 15% .

All that it's saying is that there's a very good probability two-thirds probability that this thing will either be up 15% or down 15% in the next year . That's what it's saying .

So you need to have a good idea that if you invest 100 grand this thing , yes , it might be 115 grand at the end of the year , but there's a good chance that it will be 85 grand at the end of the year , and that's kind of the idea of volatility and how you need to understand it .

So it's attached to risk because it gives us an idea of how much a thing can move around , and then what our appetite for that movement is is the key consideration when we think about volatility .

And there are a very significant number of smartphone owners who will check their weather every evening and every morning and they will get dressed accordingly .

And what's interesting about that is we know for a certainty weather predictions are hugely unreliable , and that's kind of got nothing to do with anything except a few factors it's the globe and it's weather and those things . It's not driven in any way by people .

So what we know is we do like certainty , and we also see it when we're in the world of elections . You know , we know that American elections are coming up sometime and people will say you know , gee , this election is happening , who do you think is going to win ?

And people will say you know , gee , this election's happening , who do you think's going to win ? As if I or you have any kind of insight into how American voters are actually going to vote . I don't even think they know how they're going to vote , but it's always . Here's the event , what's going to happen .

And the way that you make people feel calm is you give them a very confident forecast or a very confident sounding projection and you tell them with lots of conviction that Trump's definitely going to win because the sky is blue . And , as long as it sounds plausible , they'll say thank you . Well , that is amazing . They feel better and they go home .

The fact that the reason is absolutely useless doesn't matter . It's the confidence of the projection . And it's a long story , chris , I promise you I'm getting to a point . The point is we give people a cash investment and now they get something that's very valuable to them . They get certainty .

What they know is there is almost no chance that when they wake up tomorrow they will have less money than they had today . If they've got a cash investment and they feel good , things were stable and certain . What they're not realizing is that cash has a very long history of probably matching inflation .

Probably Most of the time it'll match inflation , maybe slightly better , maybe slightly worse , and so over time they feel okay because they never lost money . But then they start paying a bit of tax on the interest and in five years' time . They wake up one day and they go you know my money that's never gone down .

It doesn't buy the same amount of stuff that I used to be able to buy five years ago . And then they wake up to risk because they've traded buying power of their money for certainty . So they've lost the buying power of their money and they've had certainty every day . So I think we need to understand that volatility is kind of counter to human nature .

We don't like the volatility because it's always uncertain . But what we don't understand is we need volatility to grow our money . We need to protect ourselves against the risk that one day we cannot afford the things we own or buy today .

And I think that for me , if you ask me , at the crux of everything is understanding the difference between why volatility is not always a bad thing and understanding really what risk is . And I think that's why this is an amazing topic , because you and I can talk about this as kind of a dry thing and it's an academic thing .

But on the ground , when people are investing , they're forever trading certainty against volatility and thinking they're in a good position and regularly making kind of really bad mistakes .

So we have to explain this in a way and I think you gave me some kind of really nice talking points before and I want to talk about the first one , which is one of my favorite phrases , something we never want to experience , but it's called a permanent loss of capital . So let's get into now . We're talking about real risk , not about volatility .

I know you're going to tell me they're attached , but I think we can say volatility is like a roller coaster , and as long as the roller coaster is generally going up , you're winning . You don't want to do this because then you're really losing . So what's a permanent loss of capital ?

So that company has gone bankrupt and it's now worth zero and you will never get that money back . So that company has gone bankrupt and it's now worth zero and you will never get that money back . So you've put 100 Rand in .

That company's gone bankrupt , they've been liquidated and all their creditors have been paid , and you as a shareholder stand at the back of the queue and get zero in return for that investment . That's a permanent loss of capital . So it doesn't matter what you do , you will never get that money back .

Now , permanent loss of capital is kind of what keeps people awake at night . It's those big events that you see . It's the Enrons , the standoffs , you know all of these kind of events that we've seen where clients' money is eroded indefinitely and permanently , and that's a scary thought . We've had a few events in the bond market recently .

Bonds meant to be a relatively safe investment . Sa Taxi had a number of defaults where there was a portion of permanent loss of capital on those bonds . You'll never get that money . You'll never see it again , and that is take volatility aside , like you said , the variability that's actually just wiping out your money . It's gone .

Now there could be other things behind that . It could be fraud . We're talking about the real world , so fraud is a big driver of permanent loss of capital . Unfortunately , people tend to invest in very safe things also , like cash , and like money in the bank or money in government bonds , as an example . It's again attached to the certainty piece .

But you're right , volatility is attached to this idea of permanent loss of capital . Permanent loss of capital is not thinking about real return on capital , and that's the real risk that we see in our portfolios .

You know , I think what's important here , warren , is when we talk about these things and I think you teed up the idea of volatility and that actually being very certain in cash might not be the best place for you to be , because you need some returns . You need real returns of , let's say , 5% . Cash is not going to deliver it .

So , even though you've got a lot of certainty on your capital and a lot of certainty on the movements of your capital . You've actually got a lot of certainty on not achieving your financial goals and it's a segue into thinking about risk from a different way . So we've spoken about the permanent loss of capital .

That's how a lot of people thought about risk for a long time . Then people started thinking about volatility . Now what people talk about is the effect of uncertainty on an objective and that's the ultimate risk management kind of phrase . At the moment that's a very jargony phrase but basically it says what is the chance of you achieving your goals ?

That's actually the ultimate risk and this again it segues and loops nicely into your story about the weather and about certainty . Because if your goal is , let's say , cpi plus five is a return hurdle and you need that return to retire comfortably in 20 years . And then you go and invest in cash .

Well , you might have a lot of risk management and a lot of certainty on your capital and you probably won't lose any capital . So that permanent loss of capital idea falls away . There's no variability in the return . So your volatility is very low .

So you're managing those two risks but we can almost say with 100% certainty you're not going to achieve a financial goal , so that actually cash investment becomes a very risky investment for you as an investor .

And it's this idea of all these different risk measures and how we need to think about risk in the total context that ties this idea of risk all together quite neatly . It's a bit like you spoke about weather and you spoke about , you know , checking your weather .

It's a bit like going off to holiday for a nice beach holiday , you know , in Hermanus in July , and expecting seven hot days , you know , on the beach and you're going to be swimming . The reality is you go to , you know , hermanus in July , it's going to be cold . You might get one great warm day and that kind of that's it .

But it's a bit like investing in cash for a 20-year retirement objective . You might get five good years of cash , but the likelihood is that the climate is going to drive the asset class you know is going to drive the outcome and in the end you're going to be disappointed because you didn't get your summer holiday in Hermanus in July . That's the reality .

It's like investing in cash and hoping for real returns of five over a 20-year period . So this idea of certainty , the playoff and the trade-off , and what are your goals and that's why I say it's so dynamic , so fluid , is because , a volatility changes , b the probability of permanent loss of capital changes all the time as we go through different cycles .

And then , c your goal is very personal . In the end , that's a personal objective and ultimately , that's what should measure success in investing , not whether you invested in a company that suddenly 10x their return , or that you bought NVIDIA three years ago and now you're a millionaire . That's actually not investing . That's typically what we would call speculating .

Nvidia as a share has just absolutely rocketed and certainly it's selling a lot more stuff than it's ever done before .

It's accumulating a lot of cash , but there is no way that the share price is keeping up with the growth of the business , and so what happens is people look around and they read articles that are being kind of force-fed to them almost about how incredible the share is and how this is the mega trend of the century , and they feel FOMO , they feel the sphere of

missing out , and so they pile into NVIDIA . I see there's even an exchange-traded fund that you can buy that basically just borrows money to buy even more NVIDIA . So it's a leveraged view .

So every dollar that goes in $10 are borrowed , and it was launched a little while ago and it raised a huge amount of money and NVIDIA's share price has since fallen 13% and the ETF has fallen a lot more , and that , for me is probably a permanent loss of capital . There's no fraud . There's no corporate blurp . Nvidia hasn't suddenly gone to zero .

It's still selling a lot of stuff , but people got excited . Someone created a product and all of a sudden people who don't really pay attention to fundamentals just piled in and I don't think they're going to make their money back .

I think they've achieved the worst outcome , which is a permanent loss of capital , and I think when we talk about volatility , just understand . I saw a great kind of bit of research about shares and the American market every single day . It's up about 54 days out of 100 . So it's down 46 days out of 100 . It's up 54 days out of 100 .

And so that means if you're investing daily , you've got almost the same chance as flipping a coin as to whether you're going to make money today or tomorrow . But you push your time horizon out and I'm coming to kind of your goal setting that you were talking about , Chris .

But if you push your time horizon out somewhere around seven years , you're in the 95% chance that you're only going to make money .

So , 95 times out of 100 , if you invest for seven years in the American market , you're going to make money Not a guarantee , but now you've got a lot more certainty , which is what we're looking for , simply by buying the same thing and not worrying about it every day .

Buy the same thing , forget about it for seven years , then go and check your statement and you'll be most of the time 95 out of 100 times you'll be pleasantly surprised . That , for me , is something we can control . That's you and I can control it .

We can't control what the stock market's going to do every day , like we can't control the weather , but we can control an investment decision we make , which is to say how long am I prepared to invest ? What am I looking for ? So you used that phrase and I think it's an important one . We're looking for a real return CPI plus five . What does it mean ?

It means we want our money to grow at 5% a year , faster than the buying power is being eroded . So CPI is a measure of inflation , the way that things are getting more expensive , and we want our money to grow faster than the things are getting more expensive . Very realistic CPI plus five is a good but tough benchmark .

If you're going to do that , you are certain to have volatility . Let's give you that . It's going to go up and down , you push your time horizon out , You've got a very good chance of achieving your goals .

If you shorten your time horizon to daily or weekly or monthly or even over a 12-month or 24-month period , Gee , I don't think you or I , Chris , could guarantee anybody kind of a return over that time . I think we would be the same as the weather forecast .

Permanent loss of capital is something that we think about all the time and it can be managed , right . It can be managed through high diversification . We just don't want too much exposure to one thing and if we are buying something that is risky , we want to get paid for it , right ?

So if we're getting paid enough and we do lose some capital , it should compensate for that in a well diversified portfolio . So if you think about diversification , it's just saying , if we've got a hundred stock portfolio I mean some of our portfolios are a little bit extreme but we've got a global portfolio that's got 10,000 stocks .

Just to give you an idea , if you're one of those companies and they will they'll go bankrupt . Every year you're going to lose maybe 0.05% of your portfolio and you're going to get paid elsewhere . So that doesn't really make a difference . So we can protect for these risks permanent loss of capital through diversification .

Volatility we need to understand you can dampen volatility , but typically it's the trade-off that you're talking about . It's the certainty , relative to another asset class , how we can actually get a benefit of lowering volatility and increasing returns .

It's why everyone always says diversification is the only free lunch in investing is by diversifying asset classes that don't behave in exactly the same way we can get low volatility with a higher expected return .

So there are ways to deal with these things like permanent loss of capital , diversification , volatility through diversification of asset classes and the low correlation or low inter relationship between those asset classes . And then the financial objectives piece , which is the important piece that's driven through through asset allocation , really . So I'm just trying to .

I'm just trying to bring it to like the real world . You know , cpi plus five something we're speaking about . Cpi plus five we can achieve , but we know we need a lot of equities in our portfolio to achieve that .

On average , we need somewhere between 65% and 75% in equities and stocks to achieve that , which means we need to take on some risk , that volatility risk piece . So these are all concepts . That it's one thing . Talking about the risks , how do we actually mitigate for these risks ?

How do we manage them and I think that's an important kind of step that investors need to think about is like yes , there's risk , but how do we manage it ? What do we need to avoid , for example , permanent loss of capital , to have this event that wipes out my entire retirement savings ?

And that's not too much exposure to one entity , you know , and all those horror stories we hear about the you know Enrons and Stanoffs of this world typically that's just through poor portfolio construction . You know you shouldn't have much more than , let's say , a percent exposure to one individual name in your portfolio as an example .

So you know , all of these risks are actually manageable . I think that's the important consideration is that they're all manageable if we have a plan , if we sit down and carefully consider what our objectives are , what we're trying to achieve , and have a realistic conversation with a financial professional and advisor and so on .

I think that's such an important point and it almost this whole thing gets wrapped in something that you keep talking about . You said FOMO earlier , warren . It all gets wrapped in this behavioral bias that just haunts so many investors professional novice , you know and it's this idea of yeah , fear of missing out a big thing . You spoke about another one .

It's called loss aversion bias , so you feel your losses much more than you value your gains . You know . So you know you tend to do the wrong things .

You tend , even though we know we should be buying low and selling high , you actually tend to do the other thing , and that's why you know we need to be aware of these risks and be aware of how we manage these risks , and we probably need some help is the reality as well . But this idea of risk is so fluid and dynamic .

It's so individual , but can be managed and mitigated through sound planning , portfolio construction and goal setting . I think that's just something . I thought we'd been chatting about risk for a long time . Probably people are thinking , well , this is terrifying , now I don't want to invest , but the reality is that we can manage these risks .

We're not saying cash is a useless asset . There will be some cash . There will be some bonds . There might even be some cash in there . We're not saying cash is a useless asset . There will be some cash , there will be some bonds . There might even be some property companies .

But the decision the investor must make before the time is I'm prepared to leave that money there for a minimum of five years , ideally longer , ideally actually double that . If I do that , I'm going to have a really good outcome . I'm going to generally really have good growth and I'm not going to panic about what happens over a one or two-year period .

I'm not focusing on forecasts , I'm not focusing on and I'm using the weather again . But whatever the latest scary thing is because there's always a scary thing when you're an investor , there's always something that's going to derail the portfolio . According to the talking heads . Your job is to stay invested .

Your job is to make sure that you're correctly structured on day one . Set your time horizon long enough , by all means . Check it every now and then that's not a bad thing , fully understanding that you will check a statement one day and it will be down and that will be volatility . That's not a permanent loss of capital .

The permanent loss of capital is you decide to sell when it's done . That's a decision you make and that's a bad decision , so don't do it . So a lot of the stuff that we're talking about it shouldn't be scary unless you're not dealing with the person in the mirror . You need to know on day one that this is what's going to happen .

It is going to be volatile . That's okay . I have got a long time horizon . I'm prepared to leave the money and then you will have a really good outcome . Then you become part of the successful investors and you can brag if you want to . I don't think it's a good idea because one day it'll go down again . But the behavior management is the key .

I think Chris was right on that , and the one tip I'd love to give people listening to this is go and buy a book by Morgan Hussle called Same as Ever .

Listening to this is go and buy a book by Morgan Hussle called Same as Ever Absolutely phenomenal book and I think it gives you a great idea as to what actually works in the world of money and what doesn't . And a lot of the time the problems are yourself . That's the key and that means the solution is yourself .

You can kind of overcome a lot of issues just by managing your behavior better . And then the investment principles are diversification , spread your assets , stay invested in lots of assets all around the world , not just in one country , not just in one share and give your money time to start working . All the rest there are some others . We haven't got time now .

I think Chris and I have talked too much already . But I think the key is don't be scared , just don't get the FOMO thing . That's really the key , chris . I'm going to give you a chance to wrap up .

The headlines are either you know we're going right down the you know the bin or guess what ? Everyone , someone made a lot of money on NVIDIA .

So this idea of , like , pulling at those natural human instincts is what the media does , and so , as investors , dial down the noise and what you would have noticed , all of this risk that we spoke about is actually not headline driven risk . That's actually , that's real risk for you .

I mean , there's no doubt these headlines filter into investment portfolios at some point , but we can't manage them as investors . So what we can manage is those big drivers , those big risk levers , and to focus on those and try and dial the noise down that we hear and that drives bad behavior and that ultimately leads us to failing in our investment goals .

So I mean that's how I would wrap this . I would say let's focus on the risks we can control , dial down the noise and you know we're going to be successful investors if we do that in the end .

I think we're about to break our record for the longest podcast ever and hope to chat to you again in the future .