How Volatility Can Work in Your Favor

In my last post I talked about how difficult it can be to invest in emerging markets because they are so volatile.

Going back to the late-1980s, emerging markets have exhibited over 60% higher volatility in monthly returns than the S&P 500. Small cap stocks, as measured by the Russell 2000, have also shown more volatility than the S&P (around 30% higher).

My experience has been that the higher the volatility in an asset class or investment the higher the opportunity for investor mistakes/

Having said that, investors who are willing to accept more volatility in their holdings can actually use it to their advantage. Take a look at the annual return and volatility data for the S&P 500, Russell 2000 and MSCI Emerging Markets Index going back to 1988:

Screen Shot 2016-08-20 at 2.24.58 PM

The performance numbers were all fairly similar, but you can see that the volatility numbers were much higher in small caps and emerging markets, as expected. Now take a look at the last column. All I did here is use a simple equal-weighted portfolio of the three, rebalanced annually.

You can see that the return of the equal-weight portfolio is actually higher than any of the individual markets themselves. It’s also interesting that the overall volatility is much lower than what you see in small caps or emerging markets.

That’s because the volatility of the individual parts does not equal the volatility of the overall portfolio. If you were to take an average of the returns and volatility numbers of these three asset classes you would get 10.2% and 18.7%, respectively. The reason the returns are higher and the volatility is lower than these averages is because of (1) rebalancing and (2) diversification. While each market is volatile, they tend to experience that volatility at different times.

For example, over 28 years there were 14 calendar years where each of these markets were up, exactly 50% of the time. But only 4 times were all three down together, just 14% of the time. There were 5 years where two were positive and 5 years where only one was positive, both 18% of the time, respectively. It’s also striking that 71% of the time these markets were either up or down double digits performance-wise over a given year.

So there were plenty of opportunities to take advantage of rising, falling or different-performing markets from a rebalancing perspective. Alternatively, there were plenty of opportunities to fall prey to fear and greed by chasing after past performance or ignoring beaten down markets.

This is why portfolio construction is such an important aspect of successful long-term investing. You not only have to understand the risk/return profile of the individual asset classes or investments, but also how they interact with and complement one another.

Financial professionals often define risk as volatility. This has never made sense to me, because to earn a decent return on your capital you have to learn to accept volatility in some form. The trick is to understand where and when to accept volatility in your portfolio and how to get paid for accepting it over time.

While volatility can be painful over the short-term, over the long-term disciplined investors can use it to their advantage.

Volatility is only a risk if you have the wrong response to it.

Further Reading:
Misconceptions About Diversification


This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

The Compound Media, Inc., an affiliate of Ritholtz Wealth Management, receives payment from various entities for advertisements in affiliated podcasts, blogs and emails. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. For additional advertisement disclaimers see here:

Please see disclosures here.