This Term Gets a Bad Rap
When you have a “bad” day what are the words you use to describe that day?
What about when you have a “good” day?
Completely different words, right?!
In the financial world, there is a term that gets used in the negative sense most of the time, when in reality it refers to the “negative” and “positive” parts of investing. The word is volatility.
So often the word is thrown around to elicit fear and prompt the investor to run.
Yet in reality, the word is used to describe how far an annual return deviates from an annual standardized return over a long period of time.
According to DFA research, “The Bumpy Road to the Market’s Long-term Average” the S&P 500 Index since 1926 has an average return of about 10%. (Certainly, there are shorter periods where the average return was lower and higher than 10%).
Annual returns came within two percentage points of the market’s long-term average of 10% in just six of the past 94 years.
Since 1926, annual returns have been positive 69 times and negative 25 times.
That is volatility. For the long-term investor that volatility has provided very healthy compound returns by staying invested over the long-term.
Volatility is simply a neutral description of what happens in the markets.
The problem for most investors, and even for many advisors, is to stay invested through the volatility in order to get the appropriate long-term compounded return.
It is also because of these movements to the upside and the downside that the market cannot be timed. Only in hindsight is it clear in which years the market was up (and even way up) or down (and even way down).
Therefore, the volatility is something that the long-term equity investor should fully embrace and expect, and not fear. The market will most likely be up over the long-term, and it will also be down for periods of time. Yet, it is through these sometimes large movements that the compound return is as good as it is for the long-term minded investor.
Three things the investor can do:
- Keep short-term money available to meet short-term needs.
- Keep long-term money invested in equities for the long-term.
- Establish predictable income sources for retirement.
Then, build an appropriate, personalized, and integrated plan that works for you, and stick with it through the volatility. Sounds simple enough. But very difficult to execute on your own.
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Quote:
“Using volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.”
– Charley Munger