High Volatility Investing – What The World Needs?

High Volatility Investing – What The World Needs by Rob Matthews, Covenant Capital Management

“What the world needs now, is vol sweet vol…”

(aka “All you need is vol,… vol,… vol is all you need”)

Alright so what the world REALLY needs are high returns but that didn’t sound quite as catchy in the title – plus higher returns often come with higher volatility so it all works.

“Of course the world needs higher returns” – I know it sounds silly to say but if it’s that obvious then ask yourself why isn’t anyone REALLY offering it (or taking it)?

We have all heard the well reported statistics of how the vast majority of mutual funds fail to beat the S&P 500 index – but just how well does the S&P 500 do?

Well over the past 40 years the S&P 500 has an annualized rate of return of – are the ready for this – 8.55%.  Now some of you might be thinking “8% is not too bad – it turns $1,000 into over $25,000 in that that 40 year period!!!”

But let’s dig a bit deeper into what this level of return really means. Picture yourself at 25, just starting out in life. You have a solid job (not to mention midsection) and you want to do the ‘smart’ thing – which for a lot of us means opening a retirement account of some kind and diligently putting back money every year – all the while investing in a balanced portfolio of stocks, bonds , etc. – you know the typical ‘safe’ investments.

To be more specific let’s say you open an IRA and put back the maximum of $5,500 per year. Let’s also assume for argument’s sake that you make on average 8% per year and you aim to retire at age 65. Figure 1 shows what this plan looks like over time. You would retire a millionaire!!! You can picture it now – your twilight years spent traveling the world, going on safaris, visiting every Major League ball park in America, you can send your grandkids to the best private schools, etc.

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Figure 1: Retirement outlay for making 8% annually and contributing $5,500 each year – before inflation.

But as the wise and venerable Lee Corso would say “Not so fast my friend!” You forgot about a nasty little thing called inflation.

Let’s revisit our plan with the (perhaps modest) assumption of 2% annual inflation.  Figure 2 shows this scenario. You don’t retire with quite as much money as you thought – effectively $740k rather than $1.6M. In fact if you plan on living on a budget of $50k per year (in terms of today’s dollars) after retirement you will have enough money to last another 15 years at best. And I’m sorry to say there probably won’t be a lot left over for cruises, safaris, ball parks, or private schools for little William T. Stockton III.

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Figure 2: Retirement outlay for making 8% annually and contributing $5,500 each year but including 2% annual inflation.

So given that you have done all the ‘right’ things (started investing early, maxed out your IRA contribution, etc.), you can see that it still may not be enough. And this assumes you make at least market returns and inflation is only 2%. There is a chance for the situation to be much worse – just ask Japanese investors who have seen the Nikkei 225 index (their equivalent of the S&P 500) steadily LOSE 43% of its value over the last 25 years rather than gain 8% annually.

This is why what the world needs now is more high return (and yes high volatility) options available. Doing the ‘right’ things has a high chance of just not getting the job done.

Let’s take a look at a different scenario – imagine that when you are 25 your ‘crazy’ buddy Ted decides to make a one-time $5,000 investment in something ‘out of the norm’ – something with high volatility but with a chance at high returns (say 50%) as well. Let’s imagine he does this instead of investing in his IRA and after that he starts on the same plan as you – i.e. he just starts IRA investing when he is 26 rather than 25. You tell Ted he is stupid for taking this chance and he is just throwing his money away – but is he?

Let’s look at what Ted’s profile looks like if his crazy investment absolutely tanks and he loses 10% per year in it. Figure 3 shows this scenario. In this case of course Ted looks like a fool because he lost his $5k and has less at retirement than you ($680k rather than $740k). So now he may have to save a bit more somewhere along the line or work a bit longer to make up the difference – or just live on about $45k per year rather than $50k – big deal, his adult diapers are generic while you get the name brand.

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Figure 3: Retirement outlay for your ‘crazy buddy’ Ted who invested $5k once at age 25 in something more volatile but with a chance for high returns. In this scenario his investment tanks and loses 10% annually, but he retires in almost the same situation had he not made this choice.

But what happens if his investment sort of pans out and he makes, say 20% per year on it (less than half of what he expected)? This situation is shown in Figure 4. Ted now retires with more than SIX TIMES the money you saved – all because of that one-time $5k ‘crazy’ investment. Your best bet here is to hope he takes you along with him as HE travels the world.

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Figure 4: Retirement outlay for ‘Ted’ if his crazy one-time $5k investment makes 20% annually. Here he retires a multimillionaire.

Detractors to this argument might say “There is no such investment that can average 20% over such a long period.” Maybe, maybe not. But isn’t it worth at least entertaining the idea and expanding your horizons a bit to search for these types of investments? It just might be the most valuable ounce of pride you could ever swallow.

Now, if things actually do go as good Ted had hoped for and he makes 50% per year on his one-time $5k investment (regardless of how volatile it may seem), then Ted is probably retiring a full 2 decades before you and owns a major league ball team (see Figure 5). So is Ted really crazy for making this investment? Yeah, crazy like a fox.

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Figure 5: Retirement outlay for Ted if his crazy one-time $5k investment makes 50% annually. Here he retires a multimillionaire at age 45 rather than 65.

-Rob Matthews