Since 2009, investors have been well rewarded for owning equities. One surprising characteristic of this bull market had been the low volatility many investors have experienced. With this return of volatility to the market, a discussion of what volatility means to you as an investor seems warranted.
Volatility vs. risk in the stock market
The price investors pay to achieve inflation-beating returns is volatility. The history of the stock market has demonstrated a lot of volatility and we don’t see that changing anytime soon. Most investors think that volatility and risk are the same thing which is not the case. Properly understood, ‘volatility’ is merely a synonym for unpredictability. The word volatility has neither negative nor positive connotations. Let me share with you an example that might help you to distinguish between volatility and risk:
What is volatility?
My family’s favorite vacation destination is Lake Powell. We own a houseboat that we share with several other families. I have learned through experience that the most important safety precaution I must attend to at Lake Powell is the proper anchoring of our boat. I will sometimes have our boat tethered to four or five anchors at a time. Why? The Lake Powell area regularly experiences sudden and powerful thunderstorms. These storms come complete with white caps, driving rain, and microburst winds that are capable of sinking both large and small boats. Many inexperienced boaters have sunk boats because they were not prepared, they were not properly anchored, or they panicked in a temporarily volatile situation and let their emotions rather than sound judgment rule the day.
While the storms are volatile and scary, they last but a short time. If a boater is properly anchored, they will be safe. If a boater is prepared for the volatile storms, there is no damage to life or property.
Financial storms, such as stock market downturns, are likewise frightening but they too last but a short time. The experienced, anchored investor is prepared for the frequent, volatile gyrations equities give us. The unprepared and emotionally driven investor turns a temporary volatile financial storm into a permanent loss by panicking and selling equities at a loss. Remember, volatility itself does not lead to losses in the equities market. Rather, it’s the emotional reaction to volatility that ultimately leads investors to lose money in the stock market. In the world of investing, the anchor is having a plan. Having a plan to follow in times of market turmoil reinforces discipline and self-control to the prepared investor.
So now that we know what risk isn’t, let’s answer the question, ‘what is risk’?
What is risk?
Financially speaking, risk is the loss of purchasing power. Sometimes purchasing power is lost in dramatic fashion like when a business fails. Other times, the erosion of purchasing power is so gradual that the loss of purchasing power is imperceptible, such as in the case of inflation.
Every asset class is susceptible to its unique set of risks. Bonds are victims to interest rates, default, and inflation risks. Real estate has liquidity and market risks. Equities and commodities likewise have market risks to deal with. Fixed annuities and bank deposits are subject to inflation risks. All of these risks can erode purchasing power.
Many investors tend to either ignore the risks of their situation, or they don’t understand the risks that have the greatest potential to inflict damage. When I think of risks, I think of my personal phobia of sharks. I can’t think of anything more frightening than being attacked by a shark. My fear is shared by millions. In fact, there are many people who are so afraid of sharks they refuse to even get into the ocean.
I have done research on the frequency of shark attacks, and surprisingly discovered that of the more than seven billion people that populate the planet, on average, only ten people per year die from shark attacks. Ten. That means I have only a one in 728 million chance of dying from a shark attack. I would say my chances are pretty good that I won’t be dying of a shark attack any time soon. On the other hand, 66,000 people die from skin cancer each year. That means I have a one in 110,000 chance of dying from skin cancer. I am 6,600 times more likely to die from skin cancer than a shark attack!
It appears that, when I go to the beach, my fellow shark phobics and I are worrying about the wrong kind of risk. It’s not the dramatic, sudden shark attack that will kill us; it’s being exposed to the sun that is more likely to do us in. So, it is with investments.
The dramatic but temporary declines in the stock market, though scary, don’t do near as much damage as does the day-to-day loss of purchasing power caused by inflation. That is why it’s important to understand all the risks in your own situation and do what you can to minimize them.
The understanding that volatility is not risk and that risk is the loss of purchasing power is fundamental to becoming a good investor.
We chose to manage money for retirees because a lifetime of investment experience has usually taught these seasoned investors the difference between risk and volatility and the importance of preserving purchasing power. When you really drill down, you will find that investment decisions driven by emotion are at the core of almost all investment losses. Having a core knowledge, of what risk is and what it is not, goes a long way towards helping the investor through the inevitable ups and downs of the stock market that will be imposed on us with regularity.
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