Volatility vs Risk

“Real returns are found on the other side of volatility”

In the investing world volatility is used as a primary measure of risk.

However, once you understand volatility, you’ll realise the real risk is not investing.

Volatility makes for an excellent headline, but it is not a real risk over the long term – in fact, it can be your friend.

So, before we start, what is volatility?

Volatility is simply price fluctuation driven by market sentiment (whether people are hopeful or fearful).

Therefore, you could think of volatility as a measurement of fear.

You’ll note from the above graph that returns are not correlated with volatility. In fact, following a spike in fear the market has a habit of rising.

I agree with Howard Marks who said, “academics settled on volatility as the proxy for risk as a matter of convenience”.

It is both easy to measure and visualise.

Before we go any further, we also need to define risk:

Risk is the possibility of something bad happening, such as loss, injury or heartbreak.

Therefore, in investment terms, real risk is:

• Permanent loss of your capital (the #1 risk).
• Eggs in one basket (concentration of capital).
• The purchasing power of your cash being eroded away by inflation.
• Not being able to maintain your desired standard of living in the future.

Risk is not, I repeat NOT, short term volatility.

Whilst the stock markets are volatile in the short term, if you zoom out they only go one way… up.

Facts:

• Over any 10 year rolling period stock markets beat cash and bonds over 80% of the time.

• Over any 20 year rolling period stock markets have never lost money (they’ve provided real returns over inflation).

• In the UK inflation reduces the purchasing power of your money at an average of 2.5% each year.

When we view cash, bonds and stocks through the lens of volatility, stocks are judged to be the riskier investment.

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However, when you view them through the lens of actual risk (loss, injury or heartbreak), cash and bonds are plainly the riskier investment.

The problem we have is that inflation is a silent killer, the numbers in your bank account do not change. If you squirrel away £10,000, after 20 years it will still show £10,000 on your screen.

However, when you go out to the shops you will find that £10,000 doesn’t get you as much as it did 20 years ago. In fact, you’ll be able to buy around half the amount of goods as you might have expected.

Whilst the numbers in your savings account don’t change, the ones in your investment account move daily.

Volatility is the price of admission to the long term gains available through equity investing and this must be understood.

As Charlie Munger said, “if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get”.

Pretty brutal, but he’s on point.

Investment returns and real wealth are found on the other side of volatility.

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Daniel Crosby lays it out in his brilliant book, The Laws of Wealth:

“The sooner you can accept there will be 10 to 15 bear markets in your lifetime, the sooner you will be able to invest in a way that manages the thing you ought to fear most – the possibility that you will have insufficient funds to live the life of your dreams”.

The key thing to understand with investing is that you only experience a real, permanent loss when you sell. If you don’t sell, or regularly check your investments, then you will be unaffected by short term volatility.

As detailed in my Investing Commandments, to build real wealth (outstripping inflation) we need to invest in productive assets, such as global equities (aka, stocks/shares).

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Not putting your money to work is the real risk.

Your money needs to be making money and that money then needs to be making money, forever more. Equities provide that opportunity.

Bonds and cash provide short term safety, a respite from the scary fluctuations of the global stock markets, however that comes at a price.

A price many cannot afford to pay.

A diversified global equity portfolio is a safe and sensible option for the long term investor. Bonds simply stifle growth, they are an emotional asset – used to help you sleep at night.

Reshape your perspective from:

‘Owning risky stocks’

To:

‘Being a part owner of the greatest businesses in the world’

That is what you are when you have global equity portfolio, a part owner in great businesses. Check out my post Owner > Consumer for more on this.

Remember, whilst holding cash or bonds might feel safe as the numbers do not move much, the purchasing power of that capital is depleting. Unless you are ahead of inflation you are slowly but surely becoming poorer.

Whilst the stock market may seem scary, if you invest in a low-cost, globally diversified portfolio, your money will outpace inflation in the long term and allow you to maintain your desired standard of living.

Finally, as I mentioned at the start volatility can actually be your friend – especially if you will be regularly investing over the long term.

Pound cost averaging, which is drip feeding your money into the markets over time, means you buy at the highs and the lows. Buying at the lows means it is like a sale, where you can get more units and buying when the markets are high means you purchase less of the expensive units.

As I will be contributing to my investments for at least the next 30 years, I am more than happy when the market drops, as I get more for my money!

Remember, volatility is not to be feared, inflation is! Real returns are found on the other side of volatility.

Thanks for reading,

Tom Redmayne

Financial Planner-in-waiting/Volatility Lover

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