Understanding Stock Volatility
Portfolio Losses and Volatility
Volatility, the constant change in a stock fund or portfolio value, is normal and cannot be avoided. None the less, it scares people, or to be more accurate, downside volatility scares people, while upside volatility makes them happy. Both of these emotions can cause problems for investors.
Upside volatility, the bright side, may give investors overconfidence and make them feel like they are in control and smart. This can lead to a poor decision of increasing risk. Portfolio losses, the dark side, may cause investors to sell and lock in the loss. Furthermore, people are risk averse, and losses create twice as much pain as increases create satisfaction. Investors emotions wax and wain with volatility when they should be focused on long term.
Why volatility gets investors in trouble
Volatility of the market or an individual fund is a statistical measure called standard deviation (SD). It measures how much a fund’s price fluctuates over time. For instance, the S&P 500 has had a 60 year SD of about +/-15% of the shown price. An investor might look at that and think he can handle it. Fine, but investors don’t like surprises, and volatility can deliver them.
Here’s a fact many investors don’t realize: In the example above, one standard deviation means there’s a 68% probability that the return in any year selected at random from the sample period would be between -15 and +15 of the return shown. But that does not mean up and down movement is confined to +/-15%.
Volatility can fluctuate twice as much to +/-30%. That level is a standard deviation of 2, which covers 96% of the time. That number is not shown, but it means about 30% of the time the standard deviation will be higher than +/-15%. On occasion, even 2 SD can be exceeded.
What happens when standard deviation exceeds 1 is investors aren’t expecting it and they get the feeling things are out of control. The wider the swings in an investment’s price, the harder emotionally it is to hold on.
Here’s another example that does not use statistics, but is still surprising. William Coaker, CFP, CIMA, says: Investment professionals often tell clients, “I think the S&P 500 will be up 10 percent next year,” and clients like to hear that. But it almost never happens. From 1926 to 2004, the S&P 500 rose between 8 percent and 14 percent in only six years, an 8 percent occurrence. In fact, just 25 times in 79 years the S&P 500 returned between 0 percent and 20 percent, which is only 32 percent of the time. That means the index has been more than twice as likely to lose money or gain more than 20 percent than to experience returns between 0 percent and 20 percent.”
And another surprise–
“Even the years that we refer to as the “good” ones, in retrospect, test our mettle. For example, between 1950 and 2014, a span of 65 years, the S&P 500 ended the year with a gain 51 times (or in almost 80% of them). Not bad. But in how many of those up years do you think investors would’ve found themselves in a “losing” position at some point in the year. Every. Single. One. –If you don’t like the market today just wait until tomorrow
Translation: standard deviation does not provide a volatility number you can count on. On the other hand, volatility, by itself, has never caused a loss because by definition it is the down and up movement of market prices. Investors perceptions and media coverage are what cause volatility, so some surprising news triggers a reaction and herd mentality increases the response. Many are selling, but it’s a very bad idea to get drawn into it because selling transforms volatility into a real loss. Leave things alone and let volatility make the round trip.
The key to handling volatility is understanding it’s nature. To those investors who are not informed, volatility can be exciting or threatening and it can take a big toll on your savings. Volatility is a normal part of an investor’s life so don’t let it interfere with your goal. Downside volatility is not a threat as long as the time to needing the money is at least 8-10 years away. Upside volatility, or periods of low volatility don’t cause fear, but they are not a fee ticket to safely increase risk.
Investors who know their feelings and response to high volatility may add more bonds to their portfolio to reduce overall volatility to a tolerable level. High quality short and intermediate-term bonds have a SD about 5 times lower than the typical stock fund so they will dampen up side and downside volatility.
For those who have not experienced the big waves, it’s best to stay in calmer waters by starting with a good portion of bonds and or cash, at least until you have experienced how much volatility can throw you around.