The stock market, after going up year after year for nine consecutive years, is trying to catch its breath. Amid this pause, it has produced some down-day doozies, including February 4th’s 1,175-point sell-off, the biggest one-day point decline ever recorded by the Dow Jones Industrial Average.
Volatility is back, and with a vengeance. Through May 16, the Dow has generated daily declines of over 300 points on 13 separate occasions. This is in stark contrast to the 17-month period ending 2017, when common stocks experienced only one down day of that magnitude, and investors used any market sell-off to increase common stocks in portfolios.
Apparently, this renewed volatility is too much for many investors to stomach. According to the Institute of International Finance, retail investors had pulled out a net $40 billion dollars from global equity funds from January through mid-March of this year.
So much for buy and hold. This type of market jitters got me thinking: “Why do investors perceive heightened volatility as such a bad thing, and why are they prone to liquidating stocks during steep market sell-offs?”
Maybe a better question to ask is, “What is the difference between volatility and risk?” If we can define “volatility” as what the market has experienced through its wild swings of 2018, should we define risk in the same way?
I have an alternative definition of risk, and looking at risk in a different light might encourage you to embrace even more volatility in the short run to reduce risk in the long run.
“Risk” is the likelihood that you will (or won’t) have money available to sustain your lifestyle or to purchase something important at some time in the future when you need it most.
In other words, if you are 45 years old, employed, expecting to retire at 65 with a normal “extended” life expectancy, what are the chances you will be able to sustain your lifestyle during those years anywhere near your retirement expectations of today?
That, dear investor, is “risk.”
To have an even remote chance of making that happen, the 45-year-old will need to produce portfolio returns far greater than what is generated by the seemingly safer investments of bonds and CDs.
By embracing volatility as an ally in the short run, and staying the course in your portfolio allocation of common stocks, it will almost certainly accentuate longer-term portfolio returns.
It might be comforting to “take some profits” after a raging bull market of the past 10 years, and if you are one of the few investors whose financial plan can sustain a lifestyle at 2 percent and 3 percent portfolio returns, then by all means reallocate to a more comfortable level of bonds.
Unfortunately, most investors don’t have that luxury. To achieve a 6 percent or even 5 percent portfolio return over the next 30 years will demand an unwavering commitment to equities (stocks) in all types of markets, not only during daily declines of 1,000 points, but especially when it drops 5,000 points over the course of the year.
Global stock markets have had an impressive run over the past nine years. Are you prepared to embrace volatility during the next bear market as an integral tool to managing a portfolio that sustains you long after the next bear market has run its course?
Bill Schultheis is the author of The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get on with Your Lifeand The New Coffeehouse Investor, the third edition of his popular 1998 release. Schultheis is a regular on NPR, and lectures and leads seminars. He is a partner and fee-only financial adviser with Soundmark Wealth Management in Kirkland.