Volatility. Anyone with money invested in the stock markets has probably grown sick of hearing this word lately. In one way or another, it seems to dominate the news these days. It is usually characterized as something to be avoided – something scary and bad that has grown out of control and must somehow be contained.

In fact, our government is stepping in to try to bring volatility under control. Never mind that over the past few years, government not only failed to address the issues that led to the current state of affairs, but actually took steps to remove regulation that would have helped prevent it.

I’m not taking a political position here. I’m simply trying to point out that you can’t trust government or the financial services industry to insulate you from unpleasant investment results. Like it or not, you are responsible for your financial fate, and you’ll need understanding, discipline and the occasional ability to “find a happy place” to handle the responsibility with aplomb.

In order to understand and deal effectively with volatility, you must first have a set of clearly defined expectations against which to compare it. As of Sept. 25, the Thrift Savings Plan’s C Fund was down more than 16 percent for the year. So what? Did you think that your investment in the C Fund would never have a losing year? You were probably quite pleased when your investment in the C Fund rose by more than 28 percent in 2003, 20 percent in 1999, 28 percent in 1998, 33 percent in 1997, 22 percent in 1996, or 37 percent in 1995. Those were terrific years – gains of more than 20 percent in six of nine years.

Too bad those days are over, right? Not so fast. I can remember being quite uncomfortable during the late 1990s. I knew that a string of positive results like that were unsustainable – too good to last. I knew that because for years my firm has developed and maintained a set of expectations for a wide variety of investment asset types, including the stocks of large domestic corporations like those tracked by the C Fund. We don’t use some special intuition or superior genius to set these expectations, just basic statistical analysis using the past 80 or so years of history and some simple logic.

My firm expects to see a return from the C Fund each year equal to about 12 percent, on average, over the long term. We also expect to see the actual series of annual return values produced by the C Fund vary quite a bit from year to year. In every 100 years, we expect to see 17 years with a return of more than 30 percent, 66 years with a return between 30 percent and minus 6 percent, and 17 years with a return lower than minus 6 percent. These expectations are drawn from the actual returns produced by similar investment assets since the 1920s and have not changed since we began using them nearly a decade ago.

Now, back to my reason for concern over high returns. If you are investing for retirement, volatility is a problem. It brings uncertainty to what would otherwise be a more predictable financial future. But, it’s not just the downward volatility that is problematic. Volatility works in both directions – down and up. If you’re expecting to enjoy the upward moves without being subjected to the downward, you’re bound to be disappointed. If I expect returns to average around 12 percent, I know that a string of five consecutive years of returns over 20 percent will have to be offset sooner or later by some nearly comparable down years.

In order to put the C Fund’s current bear market performance into perspective, I looked at its past returns, going back to 1988, and assuming that 2008 will end the year where it currently stands. Tallying the number of years with returns in each of the ranges I established for my expectations yields the following: Four of the 21 annual return values were greater than 30 percent, 19 percent of the total versus my expectation of 17 percent; 13 of the returns were between plus 30 percent and minus 6 percent, 62 percent of the total versus my expectation of 66 percent; and four of the returns were less than minus 6 percent, 19 percent of the total versus my expectation of 17 percent.

Even I am surprised by how closely the last 21 years of history for the C Fund match the expected distribution. Although this is a small sample of data, it provides no evidence that the recent or any of the results over the past 21 years are unusual. Looking at the data in the context of history, only the remarkable gains of the late 1990s uncomfortably stand out – because, when it comes to the stock market, what goes up too far and too fast must always come back down.

Written by Mike Miles
For the Federal Times
Publication September 29, 2008