Equities (i.e. stocks) represent the ownership of businesses and is the only asset class that, I believe, fully captures human ingenuity. For nearly a century, a broad cross-section of mainstream equities have provided an investment return in excess of three times that of inflation and twice that of comparable bonds.
This “equity premium” is the way an efficient market prices in the unpredictability of equity returns -- i.e. volatility.
What is stock market volatility?
Stock market volatility is a measure of how much the stock market’s overall prices fluctuate up and down. The market can be up 15% (or more) one year or down 15% (or more) the next -- or vice versa, if you see my point. Volatility doesn’t necessarily mean “down a lot in a hurry” ... except maybe in the financial media. It just means that equity returns are unpredictable in the short, or intermediate, time frames. But for the long-term investor, volatility is perhaps best regarded as the “noise” surrounding equities’ higher long-term returns.
Volatility vs Risk: Know the Difference
Volatility in the stock market is routinely mischaracterized as “risk.” It’s important for investors to be aware that volatility and risk are not necessarily the same thing. Volatility is almost universally used as a proxy for risk, but to quote Warren Buffet’s letter to shareholders in Berkshire Hathaway’s 2014
Annual Report:
“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long-term, however, currency-denominated instruments are far more riskier investments - far riskier investments - than widely-diversified stock portfolios ... Volatility is far from synonymous with risk.”
Risk is defined in many different ways: e.g. interest rate risk, business risk, liquidity risk, longevity risk, etc. Risk refers to the permanent loss of capital or running out of money. Any effort to minimize one type of risk typically results in accepting more risk of a different type.
While stock market price volatility is pretty much a certainty, the markets have consistently experienced recoveries after declines. But inflation consistently takes a toll on the purchasing power of our money. Inflation represents a continuing and permanent loss of capital. You cannot reverse inflation. You can only outrun it. What outruns inflation? Well, stocks do -- over the long term.
It is true that stock market volatility can be unnerving to some. Volatility is often the reason a fear-inducedbehavioral mistake is made by selling investments that have declined, albeit only temporarily. Any near-term need for funds should always be kept in cash-equivalents or bank deposits.
I believe a more appropriate measure of risk is the probability that we fail to achieve my clients’ cherished financial goals. My entire professional life has been dedicated to minimizing that one risk.
There’s always a trade-off when trying to minimize one type of risk; minimize one type of risk and there’s generally an increase in another type of risk. The key is to match your investing and financial plan with your personal goals and objectives. Peaks and valleys have always been part of the financial markets, and I expect it to continue that way.
An analogy I like to use to help clients relate to volatility is turbulence on a commercial airplane ride. Turbulence is no fun and can be downright scary. They say that the most dangerous part of an airplane trip, and the most likely time you might crash and risk being killed is ... during the car ride to the airport! Numerous airplane trips experience turbulence, and a well-trained and experienced pilot and crew are prepared. They have likely been through similar turbulence before. Typical instruction from the pilot when turbulence is encountered is to, “Take your seat and buckle up.” Asking the pilot to let you jump off the plane at that point isn’t usually wise.
Think of me and my office as your pilot and crew during market turbulence.
Some Market Terms
Oftentimes, we hear the media use some of the following terms during a market decline. For educational purposes, let’s clarify these terms and their definitions.
“Dip” - a short-lived downturn from a sustained longer-term uptrend.
Example: Equity markets increased by 5% and maintained that level and then dipped back down to 3% all within a few days or weeks.
“Correction” - a 10% drop in the market from recent highs. Historically corrections occur an average of about every eight to 12 months and last about 54 days. (thebalance.com 3/9/20)
Example: On December 17, 2018, both the DJIA and the S&P 500 dropped over 10% and declines continued into early January.
“Bear Market” - a long, sustained decline in the stock market. If the market declines 20% from its recent high, this is considered the start of a bear market.
Example: On Wednesday, March 11, 2020, The DJIA dropped 5.9%, for a total decline of 20.2% from a record high on February 12, 2020.
“Crash” - a sudden and dramatic drop in stock prices, often on a single day or week. Crashes are rare, but typically happen after a long-term uptrend in the market.
Example: In 1929 the market crashed when it lost 48% in less than
How to Navigate Market Volatility
Embracing the uncertainty and imminent volatility of equities in the present can lead to abiding financial peace in the long run. If safety is defined as the preservation, and enhancement, of purchasing power - which, in the long run is the only meaningful definition of “money” - then stocks are safer than cash-equivalents, and even bonds, by a very wide margin.
Do not allow market movements to cause you to lose focus. A long-term, multi-generational investor stays focused on their plan - consistent with their goals and objectives, time horizon, and risk tolerance. Discuss your concerns with us.
Goals and Objectives
Defining your investment goals is the first step in creating a plan to work toward those goals. Then a plan how these goals and objectives are going to be addressed. Only after the plan is there a portfolio. The portfolio is merely the execution of the plan.
Do you know how much money you will need to retire comfortably, and remain that way?
Have we planned for expected education expenses? Other anticipated expenses?
Time Horizon
Short-term movements of the markets are unpredictable. Money invested in equities should have a multi-year time horizon in the first place. Even a couple that retires in their late 60s or early 70s still has a likely 20-30 year time frame ahead of them during retirement. Do you want your heirs or next generation to inherit a long-term portfolio of equity investments that may have served you well?
Risk Tolerance
Market downturns happen, and are inevitable. Investing in a well-diversified, properly allocated portfolio of equities isn’t the same as gambling or speculating. What level of uncertainty are you willing to accept today for the opportunity to have income and capital values potentially rising far beyond taxes and inflation in the long-term?
Discuss Your Concerns
First and foremost, you must call me for any reason with any concern. Please do not hesitate, because you are really doing me a favor by calling; it’s how I learn about the things that really matter to you and keeps me from having to guess.
We are always available to revisit your situation and review your financial holdings with you. It’s important we know of any changes in your situation, such as health issues, changes in retirement plans, employment, income needs, family situation, etc. The more knowledge we have about your unique situation, the better equipped we are to advise you.
We will certainly call you if and when something is going on that requires a decision on your part. This may happen rarely, as our whole philosophy is based on not reacting to every event in the economy and the markets. It’s always something! We do not attempt to time the market -- it’s impossible to consistently be right -- and you’ll more likely miss out on a healthy market recovery if you do. It is my view the only way to capture the full returns available in the stock market is to remain fully invested during the temporary declines.
We are deliberately relaxed, informal, and friendly -- and most of all, thankful for your business.
If you don’t have a plan for increasing your income in retirement at least at the same rate your cost of living is going up, then you may -- without realizing it -- have a plan for running out of money.
Remember — If you ever have any questions regarding your finances, please call us first before making any decisions. We pride ourselves in our ability to help clients make informed decisions.
We are here to help you! We do not want you to worry about things that you don’t need to worry about!
The views expressed are not necessarily the opinion of LPL Financial and should not be construed, directly or indirectly, as an offer to buy or sell securities mentioned herein. All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. This article is for informational purposes only. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a lawyer or financial professional. Past performance is no guarantee of future results. Information herein sourced from LPL Financial, JPMorgan.com, macrotrends.com, and The Academy of Preferred Financial Advisors, Inc. ©2021
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