Don’t fool yourself about volatility

Posted by on June 9, 2009 @ 9:14 am in Personal finance

My wife and kids are off visiting our relatives in Tokyo, and so I’m at home alone for the next couple weeks, reliving my bachelor days for a little while. Plenty of cold pizza for breakfast!

In place of the usual ritual of bathtime and bedtime stories with the kids (is there anything cuter than a three-year-old in a tub of bubbles?), I’ve lately had more time in the evening to sit down and noodle at the family finances. This got me to thinking a little bit about the various ways people do this—or don’t—and how it might affect investment behavior.

I’m one of those geeky people who use software to track all of the family expenses, account balances, and investments. I guess that’s so I can be constantly reminded that, yes, twice-a-week day care really does cost over $500 a month. But in all seriousness, I think this kind of software is a fantastic tool. I’d say my family is very diligent about saving, and I’m convinced some of this is simply because we keep track of everything. (Several years ago, I collaborated on an academic paper that more formally explored the idea that simply being attentive to spending could produce higher saving.)

Anyway, given my attentiveness, you might imagine that when my 401(k) balance took a nose dive last year (like almost everyone’s), you’d have been able to hear my groans (not to mention the sound of my white knuckles clutching the mouse) from halfway down the block.

But actually, while the market drop was very disturbing, I think my penchant for keeping track of our household finances protected me from overreacting in a couple ways: First, the summary page of our financial software shows me our overall household picture. While retirement assets make up the bulk of our wealth, I also use the program to track transactional accounts and savings accounts, loans, and the mortgage, as well as the estimated value of our cars and house (gotta love Zillow.com). Overall, despite the big 401(k) drop, I saw clearly that our total net worth was down by much less.

And second, given that I’ve seen the value of our investments bob up and down at least once a week for many years now, I think the decline probably affected me a lot less than it might affect someone who suddenly started paying attention after not being on top of things for a while. Persistent monitoring has taught me to expect significant volatility in my investments—and probably maybe made me a bit numb to it.

I suppose most people really won’t ever do the kind of monitoring that has become routine for me. That’s too bad—first, because I am a believer that this kind of monitoring leads to more saving. But beyond that, the truth is that investing is fundamentally about bearing risk. Risk and reward, that’s the deal: Taking a diversified risk enables you to reasonably expect a greater reward than what you can get on a bank deposit. A willingness to confront volatility is what ultimately differentiates investors from savers.

Many people probably aren’t cut out for this and may not have the constitution to watch their assets fluctuate through time. But to me that’s what risk tolerance is all about. So I do cringe a bit when I hear things like, “The best way to deal with your 401(k) is to not open your statements.”

I suppose if one really could stick to this plan over very long periods, it might do some good. But there’s a real danger if you’re ultimately unsuccessful in fooling yourself this way. Seems clear to me that looking regularly at your portfolio, seeing volatility, and learning to expect it will produce less trauma and potential overreaction than peeking at your statements only when you get really worried—and then realizing there was far more volatility than you ever imagined.

Notes:

• All investments are subject to risk.

• Bank deposit accounts and CDs are guaranteed (within limits) as to principal and interest by the Federal Deposit Insurance Corporation, which is an agency of the federal government.

• The link to NBER.org will open a new browser window. Vanguard accepts no responsibility for content on third-party websites.

We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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