Volatility is not Your Enemy

“Risk means more things can happen than will happen.” – Elroy Dimson

Here’s an overused cookie cutter answer you’ll hear from investment strategists and financial advisors when they’re asked how the stock market is going to perform:

We think there will be increased market volatility ahead. But we are cautiously optimistic.

You can’t go wrong with this statement because it covers all the bases.  You’ll be hard-pressed to find a market prognosticator in the financial media that doesn’t throw in the word ‘volatility’ at least once when describing the market.

Some other favorites: Volatility is back and it’s here to stay! Brace for more volatility in stocks! Will stock market volatility come back?  How to trade this volatility.

Of course, stocks will experience volatility eventually.

Stocks fluctuate. So it goes.

When the public thinks about volatility, what they’re really talking about is stock losses. No one likes to lose money so anytime stocks go down people assume it’s because they are volatile investments. When stocks go up everyone’s happy, but when they go down they must be volatile. When the finance industry refers to volatility they are usually talking about standard deviation. Finance people love to try to put everything into a measurable number, especially various forms of risk.

For the uninitiated, standard deviation is simply a measurement of the variation around an average. Think of standard deviation like a plus/minus figure. Add and subtract the standard deviation from an average performance number for a range to see how widely your results vary around the average.

For example, from 1928 to 2013 the S&P 500 had an annual standard deviation of returns equal to roughly 20%. The average return during that time was 9.6% so you can take that to mean 9.6% +/- 20% would give you a normal range of -10.4% to 29.6%. Obviously, outlier returns outside of this range exist, but this gives you a rough approximation on what happens most of the time (remember, there’s no such thing as precision in finance).

For comparison purposes the standard deviation on bonds, using the 10 Year Treasury as a proxy, during that time frame was 7.9%. So roughly speaking bond returns varied less than half as much as stock returns. All this really tells you is that stocks normally give you both larger gains and losses and bonds usually give you smaller gains and losses, which is not news to anyone. 2013 was a year in which everyone seemed to be waiting for volatility to strike, but it never really happened. I calculated the annualized standard deviation of the monthly returns for the S&P 500 to be 8.5% last year.

This was pretty great for investors considering the index was up over 30% last year. But up years don’t have to come with minimal volatility just like down years don’t have to be all over the place.

Ken Fisher shared some interesting stock market volatility data in his book, The Little Book of Market Myths.

Stocks can actually rise dramatically in volatile markets. The most volatile year ever was 1933. Standard deviation was 52.9% but stocks rose 53.9%.  In 1998 volatility was around 22% yet stocks rose nearly 29%. On the other hand, stocks can have extremely low volatility but still fall. In 1977 the volatility was only 9.0%, roughly half the long-term average yet stocks fell 7.4%. In 1953, volatility came in at 9.2% while stocks were down 1.1%. In 1973 volatility was only 13.7% but stocks lost 14.8%.

While you must view the markets from a historical perspective to understand the risks involved, over shorter time frames things never really turn out to be average. That’s what makes financial markets so interesting.

They can be a walking contradiction.

Even though the long-term average return is 9.6%, there have only been 5 calendar years (about 6% of the time) that ended with a return of 7% to 12% on the S&P 500. Average numbers are nice in theory but rarely play out so neatly in reality.  That’s why volatility shouldn’t be the only way you think about risk in your portfolio. Volatility and risk are not the same because risk and variation don’t have to occur at the same time.

Many times volatility is a statistical equation that Wall Street uses to make their clients feel more comfortable with their investment strategies.

It can help you determine your risk tolerance, but it’s not an exact figure for measuring all of the risks in your portfolio.

You should be more concerned with risk management than risk measurement.  Forms of risk management include diversification, periodically rebalancing your portfolio and having a long-term asset allocation plan in place that fits your specific risk profile and time horizon.

The biggest risk you face as an individual investor is running out of money after you retire.  Not achieving your goals is another huge risk you face. These are your real risks, not movements up or down in the markets.

Look at volatility as a source of opportunity, not something to be afraid of.

Source:
The Little Book of Market Myths