Market Volatility misunderstood…why we worry about volatility but not about gravity.

Volatility is normal and needed when investing long term

Why is it that people fear stock market volatility? Most investors don’t know what volatility is and why they fear it? If I were to ask people on the street to explain to me what market volatility is and how it’s calculated they wouldn’t know.

But for some reason they fear it. However, ask them to explain gravity and they inherently know what it is and typically don’t ever fear it, For that matter never even think about it. Some may even know it’s number. On Earth, normal gravity is a constant 9.8 meters per second squared, or 9.8 m/s2.

I contend that volatility in the investment world is akin to gravity in the physical world. Gravity is a constant and is critical to the success of most everything on earth. And everyday we reap the benefits of gravity but innately understand how to live with gravity. Visualize, if you can, life without gravity.

Well, first there would be no life as we know it as all the life giving atmosphere would be sucked out into outer space. Without gravity we’d have no walking, no baseball, no basketball, no golf, and no skiing. Basically nothing that requires us to exert force on an opposing body. And that opposing body is the earth.

I know this is esoteric and I’ll get to the investments soon. But we know that gravity exists and there are consequences from it. Dropping something precious and the result is broken pieces, falling down can be more than painful, etc. We know that “what goes up must come down.”, sometimes tragically.

But we don’t fear it, and we use gravity in so many ways to enhance our lives, most of the time without knowing it. Volatility in the financial markets is the same, used correctly and more often then not, it can be used to “enhance” investment returns. In fact, by definition volatility is good and we’ll get to that shortly.

So why do we fear volatility? One, is that everyone tells us volatility should be feared and that less volatility is better. They even go as far as saying that volatility is a measure of risk. And, two, who wants risk? But has anyone asked if this fear is reasonable and what if this market “volatility” is normal and nothing to be feared?

In fact volatility is more friend than foe and is the central force behind successful long term investing. Put another way, no volatility means no return. Imagine a life without returns, No Apple, no Tesla, no anything. This is true for not just stocks, but bonds, real estate, any investment. What would be the incentive to save or invest without getting a “return”?

Put your money under the mattress or at the bank and your pretty much get nothing as a return. Your money ain’t growing. In fact, it’s getting smaller if you account for inflation, but we’ll leave that for another discussion.

So let’s go back to the beginning, what is volatility?

“Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured as either the standard deviation or variance between returns from that same security or market index.”

Whoa, not sure I’d get that answer from anyone off the street, but we hear the word volatility constantly when we watch CNBC or Bloomberg TV.

But what you need to know is that it’s the standard deviation of stock prices over some period of time, generally annualized. Its the up and down of the markets and is always stated as a percentage.

Typically stocks have an annual standard deviation, up and down, of somewhere around 15% to 20%. What this mean is that 2/3 or 66% of the time the stock market can move up or down by roughly 18% in a year. And 1/3 of the time the market can move two or three standard deviations, 36% or more.

This is actually predicted and NORMAL. That’s right normal, just like everyday gravity 9.8 meters per second squared.

What else is NORMAL is that all this “volatility” leads to about 10% (up!) a year for stocks on average. In fact, over longer periods of time, say 10 to 20 year rolling periods, 100% of the time the market does not lose a dime. More profound, is that for a long term investor, saving and investing (dollar cost averaging annually) for the last hundred years did on average 9.8% a year. Even the last 10 years since the financial crisis that is what the market has roughly done, yup 10%+.

So my point is when you are skiing you know that much of the time, maybe even 100% of the time, you are using gravity to enhance your life. And when you are investing for the long run, volatility is your friend, and when that market volatility takes the market down, know that this is NORMAL and fight the fear. Remember that these are the times when you are on the “ski lift” going UP and at the top you are going to use gravity to your benefit!