By Adam Frinsco - The Advocates
If we’re going to be good investors, we need to work on our perception of both markets and their volatility. I say both because markets and volatility really are two separate topics, but are directly linked in investing. With markets, a lot of us have a perception that we should be able to achieve above average returns. With volatility, a lot of us have a perception that it’s uncommon in markets and that it’s going to get worse and never subside. Both perceptions are likely not true. Then there is the more common perception which links the two in an unrealistic way, that is the perception that an investor can achieve both above-average market returns while also experiencing below average volatility.
Fundamentally the above combination doesn’t work, as one of the main reason’s investors are compensated for a higher return is their ability to ride out volatile investments for a long enough period of time to capture those higher returns (think Emerging Markets or US Small Cap).
So if we’re going to agree on the below three points, we need to learn how to change our perceptions so that we can stomach healthy volatility which is required for our portfolios to grow over time:
- Humans are inherently poor investors
- The best portfolio strategy is one that consistently buys low and sells high
- The higher the expected return of a portfolio, the higher the expected volatility of that same portfolio
Perception is a combination of our past experiences and our current beliefs, which drive our behavior and choices. They can be wrong, and they can be modified. Let’s see if we can begin to modify both by providing the following examples of why market volatility and its’ emotional toll on us is actually a byproduct of our perceptions of it.
Ex: 1 – Volatility is Subjective
Bob and Julie both bought Stock XYZ, 5 years ago. Bob Looked often (left). Julie didn’t pay attention (right). Both realized the same gain, but Julie experienced a smoother and less stressful ride.
Ex: 2 – Volatility is a Function of Time
Chart A feels like a roller coaster, while Chart A within Chart B was hardly felt and looks like an afterthought. Volatility is reduced and more manageable the further out you measure it.
The common theme in the above two examples is that of ignoring the noise that surrounds our everyday lives, and basically trust markets to deliver returns over a full market cycle. Believe me, this a lot easier said than done. I sometimes wish I wasn’t so close to the action (as a financial planner) so that I could just keep saving and ignore my portfolio for months and years at a time. I try my best by not having cable and not subscribing to any financial entertainment (CNBC, Barron’s, WSJ, etc.), but I still see, hear and feel the movements on a daily basis.
If you were hoping for a more clever take away than just “trust markets, ignore the noise, and manage volatility by viewing your portfolio over longer time horizons,” I understand. However, the only thing we actually have control over when it comes to markets and volatility is our decision to pay attention to it.
I’ll leave you with one last visual, which happens to be my favorite from our entire series. The red signifies a randomly selected down day in the US stock market, while the green represents a trailing period of returns. It speaks to the above notion of both tuning out the daily noise and trusting markets over time. You choose how you want to perceive the health of your portfolio.