Volatility and Your Timeframe

I almost glossed over something important when I wrote an addendum to Allocate 25%. It reveals a critical flaw in investment research.

Allocate 25%
Allocate 25%: Addendum

The most meaningful way to study investment returns is to use the actual timeframe and the actual deposit/withdrawal sequence.

If you want to know what will happen after ten years, you do best if you investigate ten year periods. If you want to know what happens after dollar cost averaging for ten years, you do best by investigating what happens when dollar cost averaging for ten years, not by looking at a single investment and not by looking at single years.

Along the same lines, our investigations using the Fossey-Sortino Model found that it stripped off most valuation effects. Its basic timeframe was single-year intervals. We found that monthly data is useful for projecting one or two months into the future. Single year data is useful for projecting one or two years into the future. And so on. Monthly data, which is most frequently cited in academic research, produces meaningless results when it comes to the intermediate-term and the long-term.

David Dreman, James O’Shaughnessy, Lowell Miller and others have demonstrated conclusively that the standard assumptions about risk and return are FALSE. Value investing, including dividend-based strategies, reduces risk and increases returns. This is true using a variety of risk measures, including volatility.

Higher volatility does NOT assure higher returns. Quite the opposite. Higher volatility often leads to ruin.

Consider your timeframe when looking at volatile investments. The true volatility is likely to be much LOWER than most people think. Knowing this opens up opportunities.

Have fun.

John Walter Russell
April 13, 2006