How Volatility Takes Away Your Financial Freedom

Financial Freedom

This is not an article about risk tolerance, or how comfortable you are with market volatility. 

That concept is very important, because many financial decisions involve uncertainty or risk of loss.  All investors should be familiar with the idea that the volatility of your portfolio shouldn’t exceed your risk tolerance.  Your money shouldn’t make you uncomfortable.  What I’d actually like to explore is another reason why managing volatility is valuable:

Volatility takes away freedom.

To understand what I mean by that, let’s start with a different concept: liquidity.  If you want to buy something that costs $100, you generally need cash, or something that can stand in for cash.  Assets in a bank account are pretty close; most sellers nowadays are willing to accept checks or debit cards at the same price as cash.  They may even prefer it!  But even if they insist on cash, withdrawing cash at a bank branch or ATM is usually easy and either free or inexpensive.  We say all of these assets are liquid.

On the other hand, some assets (like collectibles or real estate) are described as illiquid.  Not only is it usually impossible to use them to pay for things directly, selling them typically takes a lot of time.  If you have a piece of art worth $10,000, it’s usually not as simple as walking up to some corner exchange or cash machine to get that $10,000 to spend.  You need to find a buyer and, ideally, go through some due diligence to make sure that the transaction occurs in good order.

But what if you need that money in a hurry?

You can probably make a legal transaction happen pretty quickly if you’re willing to accept much less than $10,000 and possibly pay some expedited fees.  Therefore, while there may be some hard limits on cost and time, illiquidity is mostly an approximation of how much it costs, in either money or time, to get access to the value of an asset.  This leaves you with a choice: do you want to give up some of the value of your asset, or do you want to delay being able to make use of that value?

In this sense, a diversified investment portfolio is very liquid.  Usually, the vast majority (if not all) of the assets in a diversified portfolio can be converted into cash within a few days, and the transaction costs are quite small for most securities held at well-known brokerages.  (Don’t forget about taxes, but that’s a topic for another time!)

Financial Freedom

There’s a subtle point I’ve glossed over so far: how do you know how much something is worth?

You always know what cash is “worth” at any given time, since everything else is measured by it.  On the other hand, real estate values fluctuate over time, and there’s really no way to authoritatively determine a price for it; the same goes for other illiquid assets like art.  You can get appraisals, but even the best appraisers are sometimes far off the mark.

Since investment values are updated constantly, you will know the value of most investment assets you plan to sell within a few percent (or even pennies, depending on the asset) before you even make the transaction.  Because well-managed portfolios rarely have problems executing transactions promptly, we can find out what the portfolio is worth within a relatively small window just by checking an online statement.

Or can we?  What if the purpose of the sale is to fund a large outlay, like a new home purchase or tuition payment?

You probably weren’t planning to sell right away.  Most likely, you wanted to check your balance as part of an assessment of what you can afford.  In that case, you can look up the value as of today, but what matters is how much you have once it’s time to make payment (and/or apply for a loan).  If that process takes six months, the value of your portfolio could have changed a lot.  If it falls a lot, your portfolio  might not be enough to fund the payment you planned for.  This uncertainty is why most advisors will tell you to sell those assets now and hold whatever you’ll need for any known upcoming cash outlay in a volatility-free asset like CDs or bank accounts.

Where will the market go next

Now let’s turn this around.  What if you’re trying to make this decision after your portfolio dropped 20%?

That would mean that you know you could raise, say, $100,000 in cash right now, but to do it would require selling assets worth $125,000 just a year ago.  History and economics tell us that the markets are likely to recover that ground given patience, so many investors think of their assets as "worth" $125,000 even though the current market value is clearly $100,000.

Some would choose to delay their expenditure rather than turning those “paper losses” into realized losses, giving the market time to sort things out and leaving themselves more flexibility to react to other events.  Others might proceed with the sale so that they can enjoy using the money sooner, simply accepting the losses given the inherent uncertainty about how long it would take the portfolio to recover.  In either case, this bout of volatility has pushed the same decision on us that illiquidity did: we must choose between delaying access to our money or taking an amount that is less than what we think our assets are worth.

This illustrates one more part of the decision about how much risk to accept in an investment portfolio.  Even if you sleep fine with a high-risk strategy, higher volatility has a similar effect to making your portfolio less liquid.  That means less flexibility, whether it’s to handle multiple crises or take advantage of unexpected opportunities that exceed your emergency funds.  This shouldn’t scare you away from taking on riskier assets any more than the illiquidity of real estate should scare you away from your dream home, but don't forget to factor this into your decision about how much risk to accept with your investments.

About FAI Wealth Management, Inc.: Located in Columbia, Maryland, FAI focuses on helping clients create the financial future they desire by protecting their wealth, making the most of their assets, and planning for life's uncertainties. The firm combines fee-only, fiduciary-driven guidance with highly personalized, consultative financial planning and investment services that enable individuals, families, and businesses to navigate complex life transitions. Founded in 1987, FAI currently manages more than $350 million in client assets nationwide. For more information about FAI Wealth Management, please visit the website at https://www.faiwealth.com or call 410.715.9200.

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