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Oxymorons and Roller Coasters

Oxymorons and Roller Coasters

| November 08, 2017

There are phrases and terms that don't make sense together. Jumbo Shrimp. Freezer Burn. Army Intelligence. You get the idea. When it comes to your investments one oxymoron stands out: Standard Deviation.

Before we talk about standard deviation, let's figure out what we are deviating from. Most of your portfolios investments fit into a respective asset class. That asset class has a historically-based expected return. Let's say that expected return is 5%, hypothetically. That's the expected average return. However, that doesn't mean that you are going to get a nice, neat 5% return every year. Returns come in random patterns, with some years being the highest and some being the lowest. The more spread apart the returns, the higher the deviation.

Think of it this way. Florida is called the Sunshine State. Here in Orlando there are an average of 233 sunny days. We expect sunshine here in Central Florida and complain when it doesn't arrive. But living in Florida also means tropical weather conditions from time to time. Remember Hurricane Irma? I do. When Irma passed overhead, it wasn't sunny. It was scary. The point is that while Florida is the Sunshine State, we deviate from that expectation from time to time. The more extreme the weather deviates from the expectation the greater the standard deviation.

The next question is, "why does this matter?" Because volatility matters. Standard deviation is a statistical measurement that informs us on historical volatility. For example, a volatile small cap stock you've never heard of will have a higher standard deviation while a stable, household-name blue chip stock will have a lower standard deviation.

And volatility matters because volatility can shake us from our discipline and conviction. Let's return to Orlando for another analogy. We are the theme park capital of the world with our fair share of roller coasters. We took some kids from my youth group a few years back. Wanting to be the fearless leader, I agreed to ride the sling shot. Essentially you strap yourself into a basket. The basket is attached to two glorified rubber bands. Those rubber bands are attached to two 150 foot poles, forming the world's largest slingshot.

As I was strapped into the basket, I looked at the carnie operating the machine. I wondered how much continuing education he was required to take each year. Was he a roller coaster fiduciary? My conviction was getting shaky. As I reclined back in the basket and looked at the night sky, I was wondering what level of g-force I should expect to be applied to my soft-body tissues. Furthermore, does humidity, temperature or user error create a large dispersion in roller coaster performance? My discipline to stay in the basket was wavering. The carnie asked if I was ready. I hesitated. Not wanting to wimp out in front of a bunch high school students, I shrugged my shoulders. That was good enough for the carnie as he flashed me a toothless grin and pressed the button.

Obviously, I lived to tell the tale. But I came very close to calling the whole thing off. When things get volatile in your portfolio, it can shake your discipline and conviction. If the roller coaster returns are too much you may be tempted to sell low or buy high. That's why volatility is one of the Four FactorsSM. It's important to make sure that the statistics of standard deviation support your goals and personality. Anything less and you may be the one deviating from the standard. If you'd like to learn more about your portfolio, we'd be happy to help. Click here to contact us.