Understanding the difference between volatility and risk is the single most important idea for us young people to understand as the stock market (and the economy) are going crazy all around us. The market right now is EXTREMELY volatile...I'm speaking with clients all day and believe me, it's scary out there. We all just need to hold onto one truth: market volatility is normal and so are market corrections! Understanding that nothing has changed for you as a long term investor will give you the fortitude and the faith to keep holding on...which is the single best decision you can make for your financial future right now. - GD
OK, I have to pause for a moment so that you can reread that last paragraph again, while asking yourselves why exactly, stocks are considered a “risky” investment and bonds less so? Didn’t we just determine that historically stocks grossly outperform bonds?! It’s time to shine a magnifying light on the words “risk” and “volatility,” and how we constantly conflate the two to our own detriment. Let’s start with volatility.
Volatility, strictly speaking, means the amount of movement or gyration away from the investment’s mean/average over any period of time. In other words, does the investment’s price bounce around a lot? That’s all it means. An asset that’s “volatile” will fluctuate frequently between highs and lows, but an investment’s volatility actually says nothing about the broader direction that your investment is moving over a period of time i.e.: is your money going up or down over time. The stock market is exceedingly volatile. Money invested in the stock market will wildly fluctuate in value over any short amount of time. In fact, from 1980 through 2016, for example, the stock market had an average inter-year swing of 14 percent annually.
Take a look*:
This means that the difference between the stock market’s high and low within each calendar year was quite dramatic, spanning 14 percentage points on average. That’s a lot of movement. Stuff goes up and down a lot even within every calendar year! OK, so we know now, investing in the stock market is volatile.
As Daniel Crosby, New York Times Best Selling Author of The Behavioral Investor, has said, “Bumpy markets aren’t necessarily bad markets.” In fact, this volatility works to our favor over the long term as that same chart makes clear: twenty-nine of the thirty-nine years shown ended up! Short term volatility is the price we pay for the higher returns that we will accrue over time by owning stocks. Capitalism rewards those that supply capital to the system and are accountable for it. That’s why, as we already discussed, it’s better to be an owner of capital (think about why you inherently want to own rather than rent your home) than a borrower of capital.
Not only does this make sense, but it also actually has to be true that in exchange for the stress and uncertainty inherent to the short-term volatility of stocks (omg, did you see the news…the stock market went down 20 percent today!), we get the reward of consistent long-term gains. If stocks didn’t, over time, outperform more conservative asset classes, there would be no reason for us to endure their short-term swings! Why drive ourselves crazy for no upside? If all asset classes performed about the same over the long term, we would naturally elect to invest in vehicles that don’t freak out as much day-to-day (meaning they’re less volatile). But that’s not the case.
As you can see in the chart above & below**, going back all the way to 1926(!), stocks have consistently provided substantially better returns than conservative asset classes like bonds or cash, and every single fifteen-year rolling period through this same eighty-plus-year period has had positive returns, even with all that craziness/volatility along the way. In other words, historically speaking, investing for a period of time longer than fifteen years, historically, has removed the risk of losing money in the stock market! Can you see why this might be an extremely powerful thing for us young people to internalize as soon as possible? As long as we know we’re in it for the long term—and as we will soon discuss we most certainly are—we shouldn’t sweat the temporary declines or the temporary volatility of the stock market.