If you are an individual investor, or if you have ever met with a financial advisor, I am sure you are aware of the concept of volatility, the tendency of investments to move up and down quickly. It's likely that you've heard of it in a negative way, as something to be avoided. The numbers, however, show that if you are investing for the long-term, as most people do, volatility is actually something you should embrace.
If you bought a fund that tracks the Dow Jones Industrial Average, which is considered the "safer," less volatile of the three major indices, thirty years ago then, not allowing for any fees associated with the fund, you would have returned a total of 164%. On the other hand, a similar investment in the Nasdaq Composite Index, considered more volatile and therefore "riskier," would have returned 442%. The caveat is that those numbers don’t allow for the reinvestment of dividends, which would have boosted the comparative performance of the Dow, but you get the picture.
So, why do advisors always tell you to reduce volatility in your portfolio?
While I am not making an accusation here, and certainly don’t want to propagate a conspiracy theory (lord knows the world has enough of those), but it basically because low volatility suits them better, even if it reduces your overall return. When times get tough, investors tend to call their advisors more than when things are going well. When that happens, advisors can point out to you that your portfolio is “only” down 10% when the S&P 500 is down 12%, or whatever. Then when things are going well, most people are happy with, say, a 20% return on a year, even if the overall market has gone up 25%.
That's not necessarily a bad thing. For one, it enables advisors to talk people off of the ledge and not make a bad decision to sell near the bottom of a move down. For long-term investors, staying invested is the most important thing, so that is definitely a benefit. But if you are rational enough to understand that selling out in a panic is not a good idea, even in the face of fluctuation in the value of your holdings, then it makes sense that more volatility is, in fact, a good thing.
Over time, stock values increase. That is not an opinion, it is a simple fact. It is an essential component of an inflationary economic system, which history has shown is the most effective system for encouraging growth and wealth generation in the long-term. And logically, if stocks will inevitably increase in value over time, those that move more will increase more, even if they show bigger short-term losses on moves down.
As you get closer to actually cashing out your investments, such as when you're ready to retire, the calculus shifts, of course. That is when it makes sense to reduce the volatility in your portfolio so as to protect against a big downswing just when you need to access the value in your investments, but if that time is still many years, even decades away, volatility is your friend, not your enemy.
I know that all of the above will be anathema to most advisors who have been taught since they entered the industry that reducing volatility is a major goal, but that is true only in certain circumstances. It is based on a focus on the downside, which protects the advisors and the firms they work for, but volatility is a two way street. It measures the extent of moves both up and down and when the upside is also considered, the picture changes.
I am not saying here that every investor should run out and invest only in the most volatile stocks, indices, and products available. That would not make sense if you have a relatively short time left until you will need the money, nor if you would find the inevitable down periods extremely stressful (see above, re; behavior management on the part of advisors preventing panic selling by their clients). If, however, you understand the nature of volatility in advance and have a long-term investing strategy, then don’t be afraid to include more volatile investments in your portfolio. The aim of long-term investing is to maximize returns, and the numbers show that you will better achieve that goal investing in something like the Nasdaq than you will playing it safe and investing in the Dow.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
Read Martin's Bio