On Volatility and Risk

On Volatility and Risk

October 27, 2020

With dire headlines flashing hourly and markets thrashing about, it is a good time to revisit the topic of volatility.

To be sure, when most investors think of market risk, they think volatility, the daily ups and downs of stock prices. But as I’ve written about previously, if you construct an investment portfolio where you match your assets with your time horizon (cash/short term bonds for funds you need in 2 – 3 years or less, stocks for capital you do not need to touch for 3+ years), then volatility ceases to be a source of risk, and actually becomes a potential opportunity for return enhancement.

Real investing risks come from overpaying for stocks, not matching your assets with your time horizon, being overly concentrated (owning too much of any one thing), using leverage, or most importantly, not knowing what you are doing. Yet day after day, financial commentators refer to short term stock price movements – AKA volatility – as a source of risk. Sure, if you make investment mistake #1 and are invested in stocks with a time horizon - for whatever reason - of months, weeks, days or even hours, then: 1) you are not really investing, you are speculating, and 2) you hold volatility risk. Simply put, you don’t want to be in a situation where not only do you have to be right in terms of your investment thesis, you have to be right at the right time (not just right over time).

For those who are disciplined about asset allocation: where are the opportunities to use volatility to your advantage?

  1. Put cash – dry powder (not cash you have set aside for near term needs) – to work at lower prices. This can apply to broad market sell offs and/or individual stock declines for those who have the time and wherewithal to do the appropriate research and monitoring.
  2. Reinvest dividends. Adding to stock holdings at lower prices through dividend reinvestments is a powerful way to potentially increase future returns and income as more shares are added over time which in turn can generate increased income and price appreciation gains as stocks rebound.
  3. Make regular contributions to your retirement or after-tax accounts. If you participate in a 401K, IRA or other retirement account – or have excess savings to add to your after-tax investment portfolio – than near-term volatility can be your friend.
  4. When markets are moving up and down, often certain sectors or individual stocks are doing well while others are underperforming. While I’m not advocating trying to dart in and out of holdings, for those who feel the need to take action (other than selling all your holdings and getting out of stocks due to fear rather than a disciplined long term plan), then taking some profits on winners and redeploying that capital into under-performers can be an effective way to take advantage of volatility.

 Revisiting The Flash Crash

Let’s look at volatility in the extreme as a good lesson for how ineffective trying to time near-term market moves can be. In May of 2010, during a 10-minute period, the DOW dropped over 1,000 points, its biggest drop in history at that point. Blue chip stalwart P&G plummeted from over $60 to a low of $39 and change in minutes, only to recover essentially all the losses moments later. Talk about volatility! Imagine being the poor soul who had stop losses in place to automatically sell PG if it dropped below a certain price, e.g. $50 per share. Be careful what you wish for… Of course, had you panicked and sold any long term holdings that day you would be kicking yourself – with much less expensive shoes – for having taken action that so materially damaged your financial situation; when nothing fundamental had changed. Just some guy you had never heard of with fat fingers hit an extra key or two when putting in a sell order. Should you really have been managing your long term financial plan based on that?

So, what is the difference between a market decline that lasts a few minutes and one that lasts a few months?

Really nothing for those who have appropriately allocated their assets consistent with their time horizon. The only difference is one you may have missed had you been in the shower, and the other you couldn’t miss unless you are in a prolonged coma. But how you react to it should be the same if you are prepared, which you need to be for any near-term market outcome because anything can happen in the near term. And as mentioned above, you should never be in a position with your investments that some outcome has to happen within a certain short term period in order for the result to be successful. Bottom line, keep it simple, match your assets with your time horizon, then keep calm and carry on.

Political Fallacies

I typically don’t weigh in on politics as my job is to help people achieve myriad financial goals over time, but not surprisingly I’ve been getting a lot of questions and commentaries about the upcoming election and its potential implications for stocks. As always, rather than relying on feelings, perceptions, or biases, let’s examine facts. Here is how US stocks performed over the last 30 years or so under various presidents:

Bush 1 (89-93): 51%

Clinton (93-01):
T1: 48%
T2: 163%

Bush 2 (01-09):
T1: -13.5%
T2: -26%

Obama (09-17)
T1: 81.2%
T2: 94.0%

Trump (17-current): 43%

Most investors assume stocks outperform under Republican presidents vis a via Democratic ones. The above data suggests otherwise. The reality is that there are literally thousands if not millions of variables that go into the pricing of all the companies that make up the S&P 500 stocks, let alone the tens of thousands of publicly traded securities around the world, over time. Companies like KO, AAPL, PG and myriad others have been able to crank out profits, year in and year out, for decades, regardless of who is in the oval office, or any other variable the world has thrown at them (pandemics, terrorist events, financial crises, trade wars, etc.).

If you are confused, concerned, or even better yet, looking to potentially take advantage of any volatility the election and its aftermath may offer, consult an investment professional before taking any action you may regret once the dust settles – which it always does.