Balancing Volatility & Return
Dave called wanting a second opinion.
He and his wife, Belinda, had been arguing over how to manage their portfolio given the recent increase in volatility. They acknowledged that the interest on their certificate of deposit was not that great. As such, they were open to other ideas, but Dave was very uncertain about the stock market given the upcoming election and inflation hangover.
In the past Dave had “gambled” with money in certain stocks—trying to trade in and out. As to be expected, this did not work out well. Furthermore, Dave argued that the market was incredibly indecisive. One day it’s up five hundred points and the next day it gives it all back.
At Belinda’s insistence, the couple was looking for a longer-term approach. However, Dave was surprised when Belinda argued that in order to be a successful long-term investor, they should be willing to tolerate shorter term volatility in order to earn longer term returns.
Belinda is right. Successful investors need to be prepared to see stock market assets fall by 40% in any one year and by 60% over a two-year period in order to gain the benefit of the long-term averages. Dave thought this was crazy.
In our opinion, Belinda is correct. And Dave’s response is quite typical.
We explained that six times in the past fifty years the US stock market has fallen by at least 30% over a twelve month period. On a few occasions, it has fallen by 60% over a 24 month period. And yet, over long time frames—generally 10 or more years–it still delivers returns that allow wealth creation in excess of taxes and inflation.
Furthermore, we discussed that the long term value of a business is generally determined by the amount of money a company makes. Despite this, many good companies see their stock price fall over short periods even if they continue to earn more and more money during a downturn. This was certainly true during the 2008 – 2009 downturn.
Dave countered and said he’d be better off investing in a 10-year US Treasury bond or CD, which are “risk-free.”
In assessing this we pointed out that a 10-year Treasury would pay interest of less than 4% per year. Then Dave would owe income taxes, at his marginal rate, on this return. In Dave’s case it would reduce his return by 30% leaving him with 2.8% after tax.
Then we asked Dave about the impact of inflation. He was silent.
If you accept the government’s metric, then inflation is running about 3.5%, currently. This would mean Dave’s purchasing power would actually decline by .7% each year over the next ten years.
Dave started to realize that his idea of a “risk-free” investment was riskier than he thought as it guaranteed a long-term erosion of his purchasing power.
Furthermore, we explained that there are many types of risk present upon a portfolio every day. Focusing all of your attention on just one type of “risk” can leave an investor far more exposed than they realize.
It resulted in a very productive conversation with a few key points.
Many people think they know what will happen in the stock market over short periods of time. None have proven long term success at such prognostications.
Volatility is not the same thing as risk. Risk comes in many forms and cannot be avoided. Rather it must be managed.
Turn off the news. It is not there to inform you. Rather, it exists to spin hype and sell advertising.
Short term liquidity and cash flow needs must be balanced against longer term growth demands. Most investors achieve the best results by having balanced and diversified portfolios that include a significant portion of growing businesses.
The stock market is guaranteed to be volatile—especially over shorter periods of time. Successful stock market investors focus on where they want to be ten or more years from now. Furthermore, they don’t allow short term bumps to disrupt the long term plan. As such, patience is the most valuable skill for a successful investor.