Is Volatility the Enemy?

From our upcoming newsletter:

After a few good years of market returns, it’s inevitable that the “c” word begins to be uttered throughout the investment world- and by that I mean “crash”. From cable news, to newspapers and magazines, to emails, people predict doom & gloom.

But is market volatility, especially negative volatility, our real enemy? Let’s look at an example based on the re-turns S&P 500. John Q, Investor, started investing in 2000. He invested, like clockwork, $10,000 on the first trading day of every year until January of 2014. But un-like most investors, he was given a choice to invest in the real stock market, or a magical one, where the direction was always up! The market genie told John, “Both stock markets will close at the same price on January 2nd, 2014, but the magical market will never lose. It’ll be a smooth ride up, the same positive return every year!” Given the opportunity to never agonize through a down year, John chose this market, as opposed to the “real” world, which saw major swings between Jan 2000- Jan 2014.

So, did John make the right choice by eliminating all downside volatility? In John’s magical stock market, he ended up with $168,050. He made about $18,000 on his investment and he never lost money in any year. He wanted to compare his results with his copycat brother in law Tom. (Tom matched John’s investments exactly, only he invested in the real world market). Tom had $221,793 by January of 2014. This beat John’s returns by almost 25%! Why? While market corrections may be no fun to live through, they do provide a period of time when our investment dollars go further. With lower stock prices, investors can buy more shares.

So if volatility is not our enemy, who is? I like to borrow a famous literary quote that says “We have met the enemy, and he is us”. Poor investor decision making (like John above), is the main cause of diluted portfolio re-turns.

Without risk, there is no reward.  Will the market “crash” again.  Most certainly.  It always has, and it will over and over again.  No one can predict with certainty when.  What matters is our response to it.  Wise investors will whether through them, and look at the bright side of the situation.  But this is not to say investing is without risk.  Each investor needs to answer the question, “how much market volatility am I willing to bear?”