In Praise Of Volatility

Volatility is good. While the media usually paints volatility as something awful to be avoided. It’s not. Rather than fear volatility, the rational investor must embrace it for some portion of his/her portfolio.

Why is volatility good? Because only volatile asset classes offer returns above the zero risk assets.

At the asset class level, risk and return are related. Volatility is a primary measure of risk. Volatile (risky) asset classes offer additional return over and above the zero risk (safe) return. That additional return is called the equity risk premium and has historically been about 6% for US Large Company Stocks. That’s huge. Other asset classes have different volatility (risk) and different rates of return.

Note that the relationship between risk and return only holds true for a diversified portfolio. You get return for assuming market risk, nothing else. An individual stock has the expected return of the asset class, but with a huge additional risk associated with a concentrated position. Risk that could have been diversified away is never compensated by additional return.

Volatile asset classes must offer additional return. That’s why we seek them out. If they did not, no one would ever buy a risky (volatile)  asset when they could get a safe asset with the same return. So, the invisible hand drives the price of risky assets down until a purchaser can expect a return going forward that is related to the asset’s risk.

Or, from a different perspective, if stocks didn’t have volatility, they would return only return the zero risk return.

By definition, risky (volatile) assets go up and down in random and unpredictable ways. Having deliberately sought out the risky asset, we must accept when it fluctuates in value over the short term. Of course, we clearly shouldn’t  purchase risky assets to fund short term goals.

On a random basis stocks will have periods of low volatility followed by periods of high volatility again followed by low volatility. Perfectly normal and should be expected for that portion of your portfolio. Random means it can’t be predicted, or avoided. So, when it happens, do your best to ignore it. You can take comfort that over the longer term, stocks have always returned higher than safe assets, and decreases in value have always been followed by recovery followed by new highs. It’s always worked before. On the other hand, selling during periods of volatility to “ wait to see what happens” has seldom worked before.

Having said all that, we still want to optimize our volatile equity holdings so that we get the maximum expected return per unit if risk. Savvy investors diversify globally, control costs and minimize taxes.

We also presume that the rational investor will hold enough safe assets to tide him/her over in the short to medium term and sleep well at night, while the risky assets are left to grow at the higher return until harvested at some future date.

Volatility is good. If you can’t love it, at least don’t fear it. Understand that volatile assets generate the additional real returns you need to meet your objectives.

By | 2019-06-27T19:39:07+00:00 June 25th, 2019|Uncategorized|

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