Volatility is one of the most misunderstood concepts in investing. It is usually presented as something bad and to be avoided. This is shortsighted, misleading, and efforts to reduce it can create more problems than solutions. Investors should instead welcome and profit from the opportunities created by volatile markets.
First let’s define it. Volatility is a quantitative measurement of how much prices move over some time period. The more prices move (on average), the more volatile the entity. Stocks are more volatile than bonds, which are more volatile than cash. When market commentators talk about volatility being bad, they usually are referring to the times when stock prices go down in a dramatic fashion over a short period of time. Volatility works in both directions, though. Roughly half the time prices go up. So if falling prices are bad and rising prices are good (a questionable assumption that we will examine in a moment), then volatility is only bad about half the time.
Our brains do not perceive declines and advances as being equally good or bad, though. Numerous studies from the field of behavioral finance have demonstrated that people feel as if a monetary decline of a specific magnitude feels about twice (or sometimes even more) as bad as the corresponding advance feels good. So even though stock prices may go up and down an equal amount, we feel the downs much more intensely than the ups. In a market in which prices go up and down an equal amount, it feels as if stocks went down twice for every advance.
Investors want to avoid this pain, so they construct their portfolios in various ways to reduce volatility. Volatility-averse investors buy bonds or leave money in cash, both of which are less volatile on the downside than stocks. But bonds and cash are also less volatile on the upside as well. Cash will never experience a bout of volatility on the upside. Reducing volatility has the byproduct of reducing potential returns. Returning more money than the amount invested should be the reason people invest in the first place. Is the underlying problem with the volatility of the asset’s price or the investor’s attitude toward volatility?
What would be nicest, of course is to only experience the upside volatility and none of the downside. Even though a few market pundits claim that this is possible, it is merely wishful thinking. If you believe this is achievable, you probably also believe that a plump man in a red suit with a white beard will bring you presents at Christmas without any obligation on your part.
Let’s challenge the assumption that downside volatility is 100% bad. It is very dependent on what action you take after a decline. If you sell everything in a panic, you lock in a loss. But if you treat a decline as a temporary change in prices, rather than a permanent loss of capital and don’t sell, it is merely a change in the value of an entity that never stays constant, anyway. If you go a step further and buy more of what just declined, then you are taking advantage of a lower price and increasing your potential for increased returns. The point of investing is to buy low and sell high, which somehow gets forgotten or ignored during the depths of a market plunge.
The tactic of buying more of a security after a decline only applies to large diversified groups of securities. Although this tactic can be used with individual stocks and bonds, it is far more risky and not recommended. The stock or bond of a company can become worthless if the company goes bankrupt. Companies go bankrupt every year. Industries and entire markets generally do not go bankrupt. Markets almost invariably recover from declines, even though it may take many years. Individual stocks might recover, but they also frequently never recover, especially if the company is poorly managed.
Declining prices are only bad for people who sell at the lower price. They are good for any buyers at the lower price. If gasoline prices were to fall dramatically, would that be viewed as a big negative? Not for most people. That is because we generally only buy gasoline and never sell it. So we like it when prices go down and don’t like it when they go up. If we are only a seller of stocks and never a buyer, then we should correspondingly think advances are 100% good and declines are 100% bad. But most people are both buyers and sellers of stocks throughout their investing lifetimes. Lower prices are better for the portion of our portfolios that is available for more purchases. Higher prices are better for the securities we wish to sell.
One should therefore conclude that a decline is certainly not twice as bad as a rise is good, in spite of what your gut is telling you. A decline offers an opportunity to buy at a lower price. A rise in prices is not very good for any new buying. Money earmarked for purchases should be invested at as low a price as possible to increase the potential for higher future returns.
So what should be your response to volatility? Embrace the opportunity it presents. Downward volatility presents opportunities to buy at cheaper prices. Upward volatility provides return for past purchases. Both are good. A perfectly steady market that never fluctuates does not provide any such opportunities. But the only place such a market exists is within the pages of an economics textbook. In the real world, investors are driven by emotions, and markets periodically swing from exuberance to despondency and back again.
One may question how to put this methodology into practice. Figuring out how much to invest in volatile markets can be tricky, since you never know how low the current price is compared to the ultimate low or how high the current price is compared to the ultimate high. Prematurely exhausting all your available funds only to watch the market move further is not only painful, but it misses the best opportunities. This can be solved if one adheres to a disciplined rules-based rebalancing process as described in detail in Cognitive Investing. The demonstration portfolio on this web site also provides an ongoing example of how this process works under current market conditions.
Cognitive investors welcome volatility because it offers them an opportunity to add to their returns. They rebalance their portfolios between asset classes after periods of high volatility (in either direction) and also benefit from rebalancing within asset classes. This rebalancing can provide up to several additional percentage points of return per year. It is the closest thing any investor will ever get to a free lunch. But in order to partake, you have to go to the place were the lunch is served. All it requires is a bit of understanding and the intestinal fortitude to buy what everyone else is eager to sell and sell what everyone else is eager to buy, in the appropriate amounts.
Cognitive Investing 