Volatility can be your friend....or not.

The Beechwood Group of Wells Fargo Advisors

          Volatility can be your friend….

….or not.

Joseph C. Steiniger, CFP®
Senior Vice President - Investment Officer

An old stock market saw suggests that “the market is driven by fear and greed”.  I would add “pride” to that list, but that is the subject of another white paper. Fear and greed are two sides of the same coin. Investors fear losing capital in down markets, and greed can also be described as “fear of losing an opportunity” in up markets. As market volatility increases, fear and greed increase right along with it.

Many investors treat volatility as something to be avoided at all costs. Older investors in particular focus on the issue, and attempt to eliminate it as best they can as they approach retirement.  Most investment planning advice will counsel older investors to be more conservative with portfolio management in their retirement years, reducing stock allocations and adding to bond holdings.  The advice is often accompanied with the admonishment that “you can’t afford to take risks” as you get older because you have less time to recoup losses.  A common suggestion is to align your stock v/s  bond asset allocation to your age, with your bond allocation equal to your age. A thirty year old investor would allocate 30% to bonds, and 70% to stocks. A seventy year old would inverse the weightings: 70% bonds, 30% stock.  That works well, until it doesn’t.  (For a more detailed discussion of Asset Allocation Strategies, see my white paper on TheBeechwoodGroup.com website. )

Another popular suggestion is to make adjustments in your portfolio’s asset allocation based, in part, upon your net worth. That advice will frequently suggest that wealthy investors can afford to assume the risk of a potentially higher returning investment with a portion of their portfolio, because if it doesn’t work out it will not affect their lifestyle. Young investors often get similar advice, with the suggestion that they will have plenty of time to recoup losses from failed or underperforming investments.  As with most “rules”, there are usually exceptions, or misconceptions, or situations where the rule can actually be very bad advice.

Before examining these old axioms, it might be worthwhile examining why we expose our portfolios to any volatility in the first place, and how it affects performance.   The short answer is that historically, more volatile investments, like equities, outperform their less volatile counterparts, such as bonds or cash alternatives. You can find plenty of shorter term time frames when that was not true, but many independent studies confirm that over long periods of time – certainly over the thirty plus years that most of us need to build a retirement nestegg  - stocks have, at least historically, outperformed bonds. Importantly, a statistical analysis of those historical returns can also be used to prove, but also in some cases disprove, some of these old admonitions.

I’ll begin with making the case that volatility can be your friend. There are actually circumstances when an increase in volatility will work in an investor’s favor. In general, this happens when a portfolio is in “accumulation mode”.  By accumulation mode I mean that the portfolio’s deposits and annual income exceed total annual withdrawals. In the case of personal savings, for most investors that situation occurs prior to retirement, but for many it may last much longer.  Other accounts will be in “distribution mode”.  For individual investors, this generally happens after retirement, usually at age 70 ½, when the IRS mandates distributions from retirement plans, and IRA’s. Those situation may – and I emphasize may – put the account in distribution mode. Charitable trusts and foundations present similar challenges. Some are still accumulating capital, some are in distribution mode. My thesis is this: The cash flow mode of the account -  accumulation  or distribution – should be the single most important (non- economic) determinant in formulating an asset allocation model.  

Why cash flow  must determine your asset allocation.

Let’s begin in the early stages of an account, when we are accumulating capital to fund some future expense, such as retirement, or a college tuition for a child in fifteen years.  At this stage the account is in “accumulation mode”. All of the cash flow is incoming, with no withdrawals planned in the immediate future. Investors are counseled at this point to start saving systematically, to add to their account on a regular basis. Using a 401(k) retirement plan as an example, the textbook advice is “if you use a systematic investment plan, you will garner the benefits of “dollar cost averaging”. As asset prices go up and down, you buy more when prices are low, and you buy less when prices are up. Over time, dollar cost averaging enhances returns. Disciplined investors, who stick to a plan and continue investing even in down markets - especially in down markets - will enjoy these benefits.

Most investors do know that over the long term dollar cost averaging helps. What most people do not know, is that the effects of dollar cost averaging can be so powerful that it can help investors generate a positive return even when the market does not. Take a look at the following chart:



Systematic Investing using Dollar Cost Averaging over a Five Year Period

Annual Investment







Fund Price







Shares Purchased







Share Balance






Amount Invested







Account Value







Source: Joseph Steiniger; Senior Vice President-Investment Officer This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of future results

In this example, an investor commits $1,000 per year to purchase a fund, every year for five years. The fund price in year one is $50. The price goes up and down, between $50 and $40, every year for each of the five years, ending up at the same $50 starting price. When the fund price is $50, 20 shares are purchased. In year two, the price drops to $40, so 25 shares can be purchased with the same $1,000 investment. Over the five year time frame, 110 shares are purchased, and the closing fund price per share is the same $50. At the end of the exercise, $5,000 has been invested, but the account is worth $5,500, a 10% gain, even though the return on the fund has been 0%.  During the accumulation phase of an account, volatility can enhance a dollar cost averaging program.

When accounts change to distribution mode, all of that changes. It is important to remember that accounts that are paying out distributions may still be accumulating capital on a net basis, if the portfolio income exceeds withdrawals.  For retirement “nesteggs”, this is a most important calculation. Some retirees will never need to invade their capital to fund their retirement cash flow. They have the luxury of being able to live off their dividends, or other retirement income, and no principal withdrawals are necessary. The IRS may mandate that money be moved from and IRA starting at age 70 ½, but that money is typically reinvested in another account. The “nestegg” remains intact. For those investors, no change of investment strategy is required. In fact I often treat those accounts as though they were “dual purpose” trust accounts. The income is for the retirees; the principal is really managed for “the remainderman”, typically the children.

Other retirees must use their nestegg’s capital to supplement their retirement income. For those portfolios, a careful analysis of investment volatility is required. The reason for the concern is not just that older investors should be more conservative, or that retirees should own more bonds, or that they cannot afford to absorb losses. The reason has nothing to do with fear or greed. If accounts are cash flow negative, there is an arithmetic reality that will mandate that portfolio volatility be mitigated. I call this scenario “reverse dollar cost averaging”.   

Just as dollar cost averaging works in the favor of (younger) investors who are adding to their accounts, accounts that are now in distribution mode are now penalized by “reverse dollar cost averaging”.  When markets are down, they must sell more shares to fund their necessary cash flow. When prices are up, they sell less, exactly the opposite of the beneficial dollar cost averaging enjoyed by younger investors.

The chart below tells the story:

Systematic Distributions over a Five Year Period

Annual Withdrawal   $1,000 $1,000 $1,000 $1,000 $1,000
Fund Price   $50 $40 $50 $40 $50
Shares Sold   20 25 20 25 20
Share Balance 100 80 55 35 10 -10
Amount Sold   $1,000 $2,000 $3,000 $4,000 $4,500
Account Value $5,000 $4,000 $2,200 $1,750 $400 -$500

 Source: Joseph Steiniger; Senior Vice President-Investment Officer This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of future results.

In the above five year sequence of cash flows, the account principal is exhausted before the end of year five.  The reason that most post retirement accounts which are cash flow negative (using principal for distributions), should reduce volatility is grounded purely in the math. The negative effect of volatility can be mitigated by prudent asset allocation and cash flow management, but the headwinds are working against the account. A systematic liquidation of the most volatile assets, or a pro-rata distribution of all assets in the account, would not be as effective as managing liquidations by asset class selection.

For all of the above reasons, an in depth analysis of retirement cash flows is necessary to save investors from making costly mistakes. While volatility can be utilized to enhance returns in portfolios which are still growing, accounts that are being drawn down systematically to support retirement budgets or make payments to beneficiaries must be viewed though a different prism.



                                    Important Disclosures


Wells Fargo Advisors did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed.  The opinions expressed in this report are those of the author and are not necessarily those of Wells Fargo Advisors or its affiliates.  This material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy and sell securities or instruments or to participate in any trading strategy. Wells Fargo Advisors does not provide tax or legal advice.


Past performance is no guarantee of future results.  Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification does not guarantee profit or protect against loss in declining markets. Dividends are not guaranteed and are subject to change or elimination.


Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.


Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.  Bond laddering does not assure a profit or protect against loss in a declining market.


A periodic investment plan such as dollar cost averaging does not assure a profit or protect against a loss in declining markets. Since such a strategy involves continuous investment, the investor should consider his or her ability to continue purchases through periods of low price levels.


Wells Fargo Advisors gathered this information from sources that we believe to be reliable, but makes no guarantee with regard to accuracy or completeness.  Wells Fargo Advisors does not offer tax or legal advice.  Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC (WFCS), Member SIPC, a registered broker-dealer and non-bank affiliate of Wells Fargo & Company .

 Investments in securities and insurance products are not FDIC Insured/Not bond-Guaranteed/May Lose Value