Why Volatility is Good
Prefer to listen rather than read? Pair this post with the Deliberate Money Moves Podcast: Why Volatility is Good.
My wife makes fun of my driver.
Every time we play golf, she has not one, but several “witty” comments during the round.
Every time.
But, you see, I like my driver. Yes, it’s 25 years old. Yes, it’s very small (or, I like to think of it as normal-sized as all the drivers these days look like balloons).
And it most certainly is outdated technology.
You see, similar to a tennis racket, each golf club has a sweet spot. That’s the spot on the club where it is best to make contact with the ball. If you hit the sweet spot, the ball will go where you want it to go.
The old technology clubs have very small sweet spots, but the new ones have large sweet spots.
It’s much easier to hit a blistering long drive straight down the middle with today’s drivers.
It takes more skill with mine. ☺
We can think of the range of things that can happen when you hit a ball as volatility. Sometimes you hit it straight and sometimes you’re buying a window.
That volatile outcomes from hitting the ball can be reduced with greater skill and I get more satisfaction out of hitting a long, straight drive with my tiny club than I would with one of today’s monstrosities!
What Does This Have to Do With Investing?
In our portfolios volatility is the ups and downs of the market and how our portfolio follows them. These ups and downs are required to provide higher returns over time.
Think about it – if the markets never went down, then everyone would always own them. There would be few people willing to sell.
And if few people are willing to sell, then prices must be high and remain high. So, if the prices are already high because markets never go down, then your return for being in the market would be very low (you are forced to buy at high prices).
Thankfully, this isn’t how it works.
Instead, market prices go up and down with the day’s trades.
If sellers are more aggressive today, the prices go down. If buyers are more aggressive, then they go up.
So, it is the very fact that volatility exists that we expect to get higher returns in the markets!
This Crash Was Guaranteed,…And So Is The Next One
When markets get wobbly – especially if there is some obvious outside risk, like COVID-19, investors who are only marginally committed may sell, driving prices down. That might make investors who were only slightly more committed to selling, and so on and so on.
This is why we say that when there is a stock market crash, stocks are returned to their rightful owners.
The folks who are buying stocks as they crash are doing so in the face of tremendous negative news and negative market information. They must be the “rightful owners” long-term because they know they will have to hold them long-term to win out.
But there are also those of us who do not sell in a crash. Those of us who hold stocks when they are going up and when they are going down.
We are the ones who are happy earning the long-term rate of return on our diversified portfolio.
Don’t Invest Money You Will Spend In The Next Five Years
How can we do this?
Because we have a Financial Plan, of course! And that plan has allowed us to set aside all the cash we need to do everything we want over the next 5 years.
This means that when the markets crash, we know our lives are not disrupted for at least 5 years – and the market recovers about 87% of the time during the 5 years after a crash.
Now, don’t take this to mean you just add up all your spending over the next 5 years (including college expenses, a new roof for your home, and maybe even a sabbatical in a few years).
Instead, we are holding the net cash we need over the next 5 years. We’ve planned out what our income and expenses are each year – including taxes – and set that amount aside in a savings account.
Peace of mind during a market crash? You bet!
But, How Can We Be Confident Markets Will Come Back?
Do you want a guarantee? You won’t find one.
But if we have an Investment Philosophy that remains intact even considering the “cause” of today’s market crash and we look at long-term returns, knowing we are investing for the long run, we can feel confident our strategy will fund our retirement as our plan shows.
And if they don’t come back in a year, then we have a decision to make. Do we drop our savings to 4 years of net cash and remain invested in the markets or do we pull out a year’s worth of cash at the current low prices?
That’s certainly a judgment call and I wouldn’t recommend the same course for everyone.
What Gets In The Way?
Ourselves.
You see, our entire human psychology has us running from things we fear when they appear. That made sense in the Savannah where we were fighting for our actual lives every day.
But when the markets drop, making our fear of lower wealth appear, if we run we make that appearance a reality, by selling low.
Alternatively, when euphoria appears as markets rise with seemingly no end, we can make disaster a reality by over-investing and not having a cushion for the tough times.
The markets work one way and we tend to think (and act) in an opposing way.
Here’s The Good News
Once you understand how this works, your solution becomes simple…but not easy.
By retaining enough cash to get us through the tough market times and investing in a properly diversified portfolio that we, personally, can ride through the downtimes, we get to earn the outsized long-term returns the market has offered in the past.
The truly long-term investor wins out.