Markets go through points in the cycle where it’s as if investors forget we don’t know what happens next. They’re sure of the outcome.
Unfortunately for investors, those points are at the worst possible times. When they’re certain things will stay better forever and certain things will only get worse.
Then the market teaches them a lesson. Heightened volatility is the wake-up call that uncertainty abounds.
Volatile markets like today are normal but occur just far enough apart that investors forget what it felt like the last time it happened. Each time it’s accompanied by a worrying event and gives us an excuse to try to avoid it.
But when you overemphasize volatility, you miss out on the good it offers. Nobody understands this better than Peter Bernstein:
In a sense, volatility is an important measure of risk because it reminds us of uncertainty. But in another sense, I think volatility gets much too much emphasis.
Early on in my career, I stopped managing money and became a consultant. I met a manager who was responsible for a large family trust that, for a variety of circumstances, would not distribute its principal for a long time. So, the only thing that mattered to the beneficiaries was the income. This manager said to me that the way we should deal with this portfolio was to put it all in stocks and to the greatest extent possible grow the stocks because the only thing that mattered to this family was to have an income that would keep pace with inflation. He said he didn’t care whether the stock market went up or down. In fact, he liked having it go down: If they had profits, that would make it less expensive to take capital gains and change from Stock A to Stock B.
If you are a long-term investor, if the fund you’re managing exists into perpetuity, then we must not overemphasize volatility. In many instances, volatility will be a friend rather than an enemy. Indeed, I think the fascination with volatility leads to bad decision making. Success in equity investing must depend on an appetite for volatility. The smooth stuff is not where you make money. You’re not going to get rich on Treasury bills. The ability to take risk and to go somewhere and have success depends on a set of human relationships just as much as it does on the mathematics of it.
In this instance, I think volatility is something that has to be straightened out at the beginning of the relationship as far as how much the investor can stand. The emphasis on smooth return, on smooth earnings streams, leads to bad things.
Bernstein’s comment rings true whether you’re investing for a multi-generational trust or a retirement. The only difference is how you diversify the portfolio.
Portfolios, in general, are built based on goals, needed returns, and aversion to risk. The hard part is knowing how much risk you can handle — how you’ll react to bad events — when you initially build your portfolio. Especially, when you’ve never experienced a bad event before.
The trouble lies in how much investors overestimate their ability to handle bad events. The result is they often react adversely during periods of higher volatility and disrupt the compounding in their portfolios in the process.
It’s almost as though investors peer farther into the future, the more certain they are, but the moment uncertainty seeps back into their brain, their focus shifts to no more than a few months ahead.
They do everything in their power to rearrange their portfolio to avoid the big worry of the day. Rather than ride it out, they try to dodge recessions, inflation, rising rates, wars, and other crises. In so doing, they leave their portfolios ill-positioned to seize on the recovery. Any benefit earned from briefly compounding stock returns is disrupted at best or faced with a huge setback at worse.
It’s safe to say volatility is in constant need of a good reframing. It has its benefits too.
As Ben Graham said, Mr. Market has its crazy moments. You can use those moments as an opportunity to grab values or you can leave things alone. Frankly, there’s no shame in not looking for opportunities. But whatever you do, don’t let price moves alone be the basis for any investment decisions.
So build your portfolio around the fact that volatility is bound to rear its ugly head. It’s the price we pay for the chance at a higher return than we can earn from bonds.
If you understand your tolerance for the worst days, you can build your portfolio to earn those higher returns and stay invested in stocks. That’s the key. Compounding works best when it’s uninterrupted. It also means you no longer have to concern yourself with the latest crisis and daily moves in the market.
Risk: The Hottest Four-Letter Word in Financial Markets