How to cope with volatility

Field of play

Some real world experience

J.P. Morgan is reputed to have said, when asked about the future course of stock market prices: “They will fluctuate.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p. 23. Simple and obvious as this observation seems, it contains a truth that investors need to reflect on.

Volatility is the up and down swings of the stock market, or of individual stocks, that takes place constantly. Volatility can refer to movements over the course of a day or even part of a day. It can also refer to swings that take place over months or years. Many investors have an instinctive dislike for volatility. It is almost like a fear of spiders or other creepy crawlies.

This sells newspapers

The financial press and stock market pundits take advantage of this aversion to report regularly on volatility statistics. The stock market ‘plunges’ 1.5% in a day and the media has a field day reporting on the number of drops exceeding one percent that have taken place in the last year compared with the average in the last decade. This sells newspapers and draws eyeballs and ears.

Cognitive behavioral therapy

Various questions come up about volatility. Should we ignore it? Can and should we try to avoid it? Or even, can we take advantage of it? The answers to these questions should not depend at all on whether we have a negative visceral reaction to volatility. It should depend on what is best for our investment results over the long term. If an investor really has a bad reaction to volatility, the answer is not to hide one’s head in the sand. It is better to read about it, learn all you can and gradually desensitize yourself to market swings.

Fear of spiders can be conquered by learning how many are poisonous in your geographic region and, of the ones that are poisonous (very few), what is the consequence of being bitten: risk of death or something like a mosquito bite. This might be coupled with purposely touching spider webs and even touching or picking up a spider. This approach is somewhat akin to a course of cognitive behavioral therapy.

As with most things about investing, the way to learn is to read avidly on the subject and then get some real world experience. We will make some mistakes, but we can learn from them. They are the tuition fee.

Ignoring stock market volatility is not a bad course of action. Better though is to take advantage of it. Worst is to seek to avoid it by focusing on buying low volatility stocks.

Go to the ivory tower

Columbia Business School (CBS) publishes a quarterly investment publication titled ‘Graham & Doddsville’. Each edition contains, amongst other things, interviews with money managers who have taken their inspiration from Ben Graham and Warren Buffett.

The most recent issue caught my eye on the subject of individual investors and volatility. The interview was with Gavin Baker of Atreides Management. The interview was largely intended as advice for students at CBS who are intending to enter the investment industry. It was not directed to individual investors.

But it seemed to me to offer words of wisdom to individual investors on three subjects: 1/ How individual investors should deal with volatility; 2/ How much more difficult it is for professional money managers and professional investment advisors to cope with volatility; and 3/ path of returns.

Here’s what Gavin Baker said:

“You can get taken out of the game by your clients or by the management of your firm. So, volatility and the path of returns matter if you’re going to be a professional investor. If you’re an individual investor, none of that matters because you know when you’re going to buy a house. And maybe you do something different in your portfolio and raise a little cash the year leading up to it, whatever it is. If you’re an individual investor, go to the ivory tower, live at the top of it and preach about 5-to-10- year returns with a lot of volatility. But anybody who’s reading this and is going to be a professional investor, that is a luxury you will not have.” [emphasis added]

He goes on: “Maybe a couple of people on this planet have client bases that are aligned with a high volatility, 5-to-10-year return stream that might see several 30% drawdowns on the way to a superb 10 year record. To get a client base to sign up for that is one reason why, if you ever want to run your own show, you have got to be a good communicator.” [emphasis added]

Graham Doddsville_Issue 43_vF (004).pdf (columbia.edu)

Volatility

He’s actually mistaken about the investment horizon of individual investors. When you are young, your investment horizon is your life expectancy. At age thirty you might have a life expectancy of ninety, i.e. a 60 year horizon. Personally I’m at the other end of the scale. But, my investment horizon is the joint life expectancy of myself, my wife and my children, which is about 40 years. So, when Gavin Baker talks about “5-to-10- year returns with a lot of volatility”, he should be talking about “40-to-60 year returns with lots of volatility”.

So, to use Gavin Bakers metaphor, you “go to the ivory tower, live at the top of it and preach about [40-to-60- year] returns with a lot of volatility”.

As for 30% drawdowns, I’ll tell you of my experience. One way or another I have experienced or avoided every drawdown in the stock market since 1972. My default asset allocation is 100% individual common stocks. I’ll tell you about 2008 as a case in point. From late 2002 I had been 100% in individual stocks. I retired in 2005. Through 2007-08 the financial crisis unfolded. I did not change my asset allocation. I stayed 100% in stocks. In 2008 our financial assets, on paper, declined about 37%, about the same as the S&P 500. I can’t pretend to say I wasn’t concerned. But, I had been investing for over 35 years at that point and I had a plan in place and a financial crisis was not a time to change the plan on the fly. Incidentally, any investor with an S&P 500 index fund would have seen the same volatility.

As events turned out, in early 2009 one of my stock holdings was acquired by its parent at a 30% premium to the market. I was able to redeploy the funds to other investments at very attractive prices.

My assessment in 2007 at the top of the market was that the stock market was not in a bubble. What crushed stock prices was a financial crisis brought on by sub-prime lending, disastrous investments in derivatives and other assorted financial shenanigans.  

In the spring of 2009 the stock market started to recover. I remained 100% invested in stocks from that time to the present with a compounded total return from January of 2009 to present of 15.79%. This is the performance according to my discount broker’s calculation on all our financial assets/retirement savings taking cash flows into account. This, in effect, gives an Internal Rate of Return (IRR). Holding the course proved to be the right decision.

Path of returns

Path of returns is an interesting subject although I don’t pay much attention to it. Let’s say portfolio ‘A’ has annual returns over a five year period 8%, -3%, 8%, 15%, and 8%. Now let’s look at portfolio ‘B’ with returns over the same period of 15%,-3%, 8%, 8% and 8%. If each portfolio starts with $100 and nothing is added or taken out, the outcome for both portfolios is identical.

However, if the investor is adding $10 of savings to the portfolio each year, the results will be different. Intuitively this is because the 15% return in portfolio A in year 4 has more money to work on. That is because $10 has been added to the portfolio each year. What we have just looked at is the dollar weighted rate of return, taking cash flows (i.e. money in and money out) into account. So, the path of return makes a difference. It just doesn’t make enough difference to cause me to modify my approach to investing.

Conclusion

I agree with Gavin Baker when he says: “, volatility and the path of returns matter if you’re going to be a professional investor. If you’re an individual investor, none of that matters…” The only thing I would modify about this is that the investor can also take advantage of volatility. When prices are down stocks are less risky and there are more stocks available at very attractive prices.

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My basic strategy is 100% allocation to stocks. I do have one exception around true stock bubbles. If you want to read up on this approach, see these posts:

My thoughts on asset allocation

What you need to know about bubbles

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If you find yourself in the middle of a serious market drawdown, take a look at these posts:

The great investors and extreme volatility

Keeping your head in times of turmoil

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You can reach me by email at rodney@investingmotherlode.com

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