Volatility, by Its Proper Name

Category: Blog

Confucius said that the beginning of wisdom is to call things by their proper name.

And a century ago, a pioneer in the field of linguistics named Edward Sapir noted that the “real world,” as people experience it, is very much based on the way their culture uses language. “We see and hear as we do,” he said, “because the language habits of our community predispose certain choices of interpretation.”

So let it be with that most overused, least understood word in investing: volatility.

As a general statement, the vast majority of investors process the word volatility in relation to the equity market as meaning sudden, sharp downward movements in stock prices which cause them to lose money.

It doesn’t mean that at all. And by itself it doesn’t cause anyone to lose money. Let’s start there.

Properly understood, volatility refers to the rate at which the price of a security increases or decreases for a given set of returns. It shows the range to which the price of a security may increase or decrease around its longterm trend. That is, the concept of volatility simply refers to the extent of variability, up or down, from the norm.

It hasn’t got any negative connotation at all—nor, if this makes you feel any better, any positive connotation, for that matter. It cuts both ways.

If the prices of a security fluctuate rapidly, both up and down, it is said to have high volatility. If prices fluctuate slowly in a longer time span, the security is said to have low volatility. It’s the extent of the fluctuation that determines volatility. The equity market can be up 20% one year and down 20% the next (or vice versa, if you see my point). Doesn’t happen often, but it can. Bonds rarely if ever do that, or anything close. What does that suggest? Simply that equities are more volatile than bonds. But that isn’t what goal-focused long-term investors should be concerned about. Rather, we should care—very much—about their long-term return, absolutely and relative to each other.

Our friends at Morningstar/Ibbotson tell us that, since 1926, large-company equities have compounded at just about 10%. The most directly comparable corporate bond index has compounded at about 6%, and CPI inflation has been just about 3%.

As a long-term investor, I personally don’t put much credence in nominal rates of return—in this case, the 10% and the 6%. I’m more interested in real returns—net of inflation. When I apply that criterion, I determine that mainstream equities have compounded at 7%, and bonds at three. Stated another way, over these last 90-odd years, equities have returned in real terms more than twice what comparable bonds did. But why?

It certainly wasn’t risk, at least not historically: there is no 20- year period (starting from the first of every month) since January 1926 in which the S&P 500 (or its forerunner, the S&P 90) produced a negative return with dividends reinvested.[1] Which suggests to me that the very reason for stocks’ premium long-term return must have been their shorter-term “volatility.” That is, an efficient market simply demanded higher long-term returns from the asset class with the much higher short-term variability.

If that’s true, then volatility, properly understood, is actually the friend of the long-term investor. Warren Buffett certainly agrees with that thesis. He’s been quoted as saying that an opportunistic buyer like Berkshire Hathaway would actually prefer higher volatility—because it would cause more people to make bigger mistakes.

Don’t read past that too quickly. Because it implies that selling into a falling market, i.e. giving in to fear of downward volatility—tends to create a long-term opportunity for the buyers of the stocks you’re panicking out of.

That might be something to try to remember, the next time the market hits an air pocket, and media once again begin shrieking on cue about “volatility.” I’m sure your financial advisor has said this to you a dozen times: when you want out of equities no matter how low the price has gone, somebody, and maybe a bunch of somebodies, are happily buying your stock from you.

Now, maybe that’s because you’re a whole lot smarter than they are, and you understand the gravity of the situation better than they do. (I can’t rule that out.) But it just may be that they know something you don’t, or have chosen to forget: to wit, that “volatility” isn’t the same as risk, and temporary decline isn’t the same as permanent loss—unless and until you sell.

© September 2019 Nick Murray. All rights reserved. Used by permission.

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