Volatility, Risk, and Financial Planning

Market volatility is back and ready to test our patience. I’ve come to believe volatility never really leaves the market, it just periodically and without notice switches direction. Here’s a recent example.

In 2022, owning companies didn’t feel so good; neither did lending your money to them as returns posted -18% and -17% respectively.  Regardless of where you directed your dollars, it was a challenging year to be optimistic. 

But then the tides shifted. The S&P 500 index expanded upwards in 2023 and 2024 generating consecutive 20%+ returns each year. This rare sequence hadn’t occurred since a 20%+ run back in 1996 through 1998. So, what can volatility teach us?

Volatility is linked to prices, and moves both ways, up and down. Our brains like to frame volatility in negative terms, but that’s just not true. We’ve experienced positive volatility the past two years as America’s largest and best companies generated impressive earnings that elevated stock prices. 

Risk is not volatility. Risks are negative outcomes or the potential for bad things to happen by not making good decisions. Owning one company instead of many, not wearing your seat belt, or spending more than you earn are all risks with varying consequences. Risks can also be simple like skipping breakfast and then overeating at lunch—not all risks are complex.

How can we integrate volatility and risk into financial planning? It starts by understanding the difference between each and redefining what financial planning is. My definition of planning, rather simplistically, is sustainable cash flow for spending. Why make time for planning? The answer for me is obvious—so you can make better decisions spending what you have.

Sadly, cash flow isn’t always transparent. There are numerous ways to spend your money and small details that increase complexity. These include taxes, cash reserves, and having to make investment decisions so you have cash to spend in the future. Add in real life expenses that are lumpy and spending can be a challenge. 

If that wasn’t enough of a hurdle, there’s one more and it’s a biggie. Inflation, the constant rise in the cost of life requiring your spending to stay relevant. When you define financial planning as managing cash flow, where you invest today will influence tomorrow’s spending.

There are countless investment choices available, each with their own volatility and risk assumptions. I’m keeping it simple and comparing owning companies versus lending your money to companies.

Owning companies have historically generated gross returns of 10% +/-, while lending your money to companies has generated gross returns of 6% +/-. The difference in return is that investors expect (demand) larger returns for owning companies.  Why? Price volatility.  Owning companies will have much bigger price swings than lending your money to them. 

That’s half the picture. Regardless of the investments you select, both are affected by inflation, roughly 3%, over the long run. So net returns are 7% +/- by owning companies and 3% +/- by lending your money to them. 

It’s never a straight line or as straightforward as it sounds. Our emotions often trip us up and have us reacting to short-term swings with our long-term dollars. It’s up to you and perhaps counseling from a friend/financial planner to determine which investments are best suited to meet your spending needs. Thriving through a three-decade retirement won’t happen on its own.

It’s important to have enough to live comfortably and independently as you age, with a plan to address your care needs without burdening a spouse or adult children. IMO this is what cash flow is really all about. 

Unfortunately, I don’t see these conversations taking place as frequently as they should. Instead, I see a lot of hype on companies under/over performing, transactions, fear, economic projections, recession readiness, and a lot of other noise that doesn’t matter in the long run. 

The only thing that matters is cash flow and having enough to spend where you want to. Everything else is an enormous distraction. When you think about financial planning in terms of spendable cash, clarity tends to arrive. 

The less traveled path is creating (and updating) a financial/cashflow plan around what you want when you want it. Your timelines will help provide a clear understanding in selecting the proper investments. In the absence of a plan, investors are left to guess which investments will perform best, which increases risk and does not address cash flow.

I feel it’s best to create a plan around spending, update it annually, and then go live your life with less worry and regret. This ensures you control your cash flow instead of it controlling you.

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