We’ve all heard it before, “The stock market is too volatile!” Investors, analysts, and your brother-in-law’s best friend, the one who suddenly became a market expert after reading an article, all seem to grumble about the ups and downs of the market. But here’s the question — is this volatility really such a bad thing?
It’s clear that the stock market has been one of the most effective wealth building tools over the past century. The market’s ability to compound wealth over decades has made it a powerful mechanism for long-term growth. What if I were to tell you that market returns are largely attributable to its volatility? Sounds counterintuitive? Let me explain.
In investing, there is a concept called the Efficient Frontier. It’s a curve that shows the best possible return one can achieve for a given level of risk. Usually, risk is plotted on the X-axis and returns on the Y-axis. Higher returns require taking on greater levels of risk.
In reality, the better way to view this concept is to exchange “Risk” for “Reason”. When an investment has a higher expected return, it does not always mean it carries more risk, rather, it means there is a significant reason for its higher expected return.
If we were to plot a standard investment on the chart above, beginning with the bottom left, we would see that the safest asset (for example, U.S. Treasuries) presently shows yields of approximately 4%. Any investment that promises more than that – meaning it has a higher expected return – must be accompanied by a “reason” that will move it out further to the right of the chart.
What could be some reasons for higher expected returns?
- Loss Exposure. For example, real estate and private businesses have a higher expected return than treasuries, as there is capital at risk.
- If a bank CD is locked in for a long period, it doesn’t necessarily mean it is a riskier investment. However, the extra limitation period will create the demand for a higher return.
- If an investment is volatile, investors will expect a higher rate of return.
To put it briefly, if there is no reason, there is no extra return.
Let’s focus a little more on the last factor on the list, volatility.
The stock market represents the ultimate in volatility. Some years, it may be up 30%, while other years it may swing 20% downward. If you focus on any one year, the picture is chaotic; but if you consider the market’s long-term average, the picture becomes much clearer. The U.S. stock market has returned approximately 10% annually over the past century. That return isn’t an accident – it is the reward for enduring volatility.
If the stock market were as stable as a savings account, it wouldn’t return 10%; it would return something closer to 4% – like Treasuries. If the market would be as safe as Treasuries, investors would bid up prices where the effective yield would be similar to the risk-free rate. The volatility is what creates the opportunity for higher returns. With no volatility, there would be no reason for stocks to outperform.
Instead of being disturbed about market volatility, why not embrace it?! Volatility is not your enemy; it’s your ticket to higher returns. Volatility is a reason you get paid more. It’s the price you pay for participating in one of the greatest wealth-building mechanisms ever created. Beyond that, volatility offers opportunities to invest at times when investments are at reduced or discounted rates. Sir John Templeton put it best when he said, “For those properly prepared, the bear market is not only a calamity but an opportunity”.
This material has been prepared for informational purposes only and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
