by Craig Swanson, Senior Asset Manager, Wealth Enhancement Group

As the past decade has shown, the capital markets are volatile. However, it is not that volatility, per se, that complicates financial planning. The real culprit is that the direction and the magnitude of the volatility are almost entirely unpredictable. If we knew which direction prices would move on a given day, then volatility would be our best friend. Yet because movements are unpredictable, the effects of volatility can be unexpected and harsh, and as most of us have experienced in recent years, the effects of an unexpected generational volatility event can go beyond harsh to having a major impact on financial planning.

We have, over the years, been taught by the media that the stock market advances, on average, a certain percent every year. Many sources quote an historical 8% annual return. Having this number engrained in our investing consciousness, it is easy for people to misinterpret it to believe: "If I invest $100,000 now, then in five years I should have right around an average gain of 8% per year." Of course, if it happens to be right before the start of a protracted bear market, the investor might do well to simply break even over a five-year time horizon. It is easy for us to intellectually understand this, but when the time comes to actually make investment decisions, people frequently fail to plan for the worst and instead expect "average" results in their portfolios.

A method used by some professionals to combat unknown future market volatility is to segment investments based on when distributions will be needed. For example, cash needed one year from now would be invested in a "short-term" segment, while cash needed twenty years from now would be invested in a "long-term" segment. As time passes, the investments in the longer-term segment migrate down the time horizon and are converted into investments that are shorter-term in nature. This begs the question, of what makes an investment longer-term or shorter-term in nature.

To a large extent, the time horizon of an investment is based on its volatility. Many scholars believe that more volatile assets reward investors, over time, with higher returns. But the fine print is that it does so on average and over the longest of time horizons. For example, a single small cap stock might lose 50% of its value the first year after it's purchased. This means that from the new, lower, value it needs to gain 100% in order for the investment to get back to even. Contrast that to a U.S. treasury bill that might lose 2% in the first year. It would only require a 2.04% return from that point to return to even. Although the long-term return on the T-bill might be less, on average, the reduced volatility makes it much more attractive if your goal is to preserve that capital and have a somewhat certain level of investment income for the year.

Volatility is not necessarily a bad thing. Over the long-term, investors can presumably make volatility work to their advantage. Over the short-term however, no one can predict which way market prices are going to move. For this reason, your distribution plans need to carefully consider the effects that unexpected volatility might present.