Financial Savvy: Investment Risk vs. Stock Market Volatility
When the stock market goes crazy, people go nuts. The ensuing insecurity has them thinking that stashing their money in a mattress at home is safer than investing it anywhere with anyone. But one should know the differences between risk and volatility to avoid silly and irrational investing mistakes. Let’s clear the confusion once and for all. We want to help you see clearly how to improve your performance as an investor. What is the difference between stock market risk and stock market volatility.
Update Investing Today: From Jan 2, 1969 – Dec 31, 2019, 7 of the best 10 days in the market happened within 2 weeks of the 10 worst days. In fact, the best day in 2011 was only one day after the worst day.-J.P. Morgan, May 6, 2020
Some good news going foward from the Stock Market Correction at the beginning of 2022.
Based on data going back to 1896, the DOW gains 2.7% a week after the index experiences a 10% correction and it gains 3.3% a month out, 5.2% six months later, and 8.7% a year afterward.-MarketWatch 2/23/2022
By David Rae Certified Financial Planner™, Accredited Investment Fiduciary™
At any given social gathering, when I hear people saying things like “I just lost $10,000 in the market today.” Followed shortly by “Even thinking about a financial plan stresses me out right now.” I know it’s just a matter of time before they conclude that investing is not for them. But what’s really happening here is that these folks are thinking that risk and volatility are the same things, when they most emphatically are not.
While risk and volatility are closely related, they’re not by any means identical. It may seem like splitting hairs to make the distinction between the two but believe me, how well you understand the difference can make or break a sound financial plan . . . and your future.
This confusion between stock market risk and stock market volatility can also easily lead to rash financial decisions. Not to mention mistakes that can cost you money in the short run and financial stability in the long run. So what are we looking at here?
Coronavirus Update: The stock market appears to be running scare from the Corona Virus. Before you make any irrational trades of moves you in your investment account, ask yourself: Do you think this health scare will change any of your financial goals? Will you still want to retire? Buy a home? Send your kids to college? Unless you are changing your financial goal, you likely shouldn’t be changing your financial plan.
By definition Risk and Volatility
- Risk is the probability or likelihood of losses relative to the expected return on any particular investment. For example, a risky stock is one that could pay out big but has a greater potential to be a loser. A risk is a chance (that may, in some cases for some investors, be worth taking).
- Volatility is just another way to say unpredictable fluctuation; in reality, it shouldn’t have any positive or negative connotation attached to it. It simply refers to the natural movement of the stock markets both up and down, and up and down again. For example, if a stock is particularly volatile that means it’s value has moved around a lot, not necessarily going anywhere. It may just be going around like a Ferris wheel, up and down but always ending in the same place.
Embracing Stock Market Volatility
Stock Market Volatility is written into the DNA of investing in the stock markets. In fact, volatility is the stock market. The stock market may be up today, and down tomorrow, or vice versa. This is true whether you own individual stocks, mutual funds, exchange-traded funds (ETF), bonds, annuities, cash value life insurance, or any other investment that trades on the stock market.
As a Los Angeles Certified Financial Planner (TM) , I’m here to tell you that volatility is par for the course when investing. Temporary declines can only be turned into permanent losses if you make some of the big investor mistakes. If you bail out of the market every time the market goes down even a tiny bit, you have no chance of ever reaching your long term financial goals, unless you are willing and able to save a huge portion of your income, and start at a young age. Even then the chances of turning your life savings into a secure retirement income stream would be nearly impossible.
Are you just sitting around waiting for the next recession? If you live long enough you will see many more. But does it even matter?
(Picture saving 30+ percent on your income per year, and starting in your twenties.) Since I’m guessing you are not in your twenties anymore and haven’t been saving more than 30% of your income, you will probably need to deal with some volatility to reach your goals.
I keep seeing tons of headlines out there in the investment world all claiming to have the magic key to ‘calm’ or ‘lower’ volatility. They assert that suppressing volatility is in some way an important part of a financial plan, or that lower volatility means lowering the risks of a particular investment or portfolio of investments. IT DOESN’T.
I can totally understand why when given a choice you would choose less volatility over more volatility. This might be a smart choice if that were all that went into the discussion. But the ignored problem is reducing volatility may actually have serious negative consequences on overall long term investment returns. To put it more bluntly the more you attempt to suppress volatility the more likely you are to end up suppressing returns.
Negotiating Stock Market Risk
I hate to spill this little secret, but the biggest part of my job is to help people avoid shooting themselves in the foot, sometimes repeatedly. Oftentimes taking too little risk (‘taking chances’ in civilian-speak) means you are limiting your opportunities of reaching your biggest and most important financial goals.
For example, if you choose to save for retirement in a fixed account after inflation – just about as risk-free as you can get – you essentially have to save every penny out of your own pocket to fund what could easily be 30 years of retirement. At the same time, you are foregoing all the magic of compounding interest.
Let’s say you saved the current maximum into a 401(k) – $20,500, each year from age thirty to seventy. If you locked that up in a CD at the bank earning 1% you would have just over a million dollars. This is a nice number for sure, but keep in mind you put in a staggering $820,000. Now if the money was investing with below-average returns, at just 7% per year, your retirement nest egg would be about $4.1 million. If you were able to earn an average of 10% per year for 40 years, would would have over $9 million dollars at age 70. Yes, your values would fluctuate, but it wouldn’t be hard to invest wisely enough (over the long term) to drastically beat the paltry income earned at the bank.
Real World Investing Scenario
In an efficient market, the more volatile an investment the greater the potential for a return. (This is confusing because of the riskier an investment, the greater the potential for return too but bear with me here.) While the real world doesn’t always work in exactly this way, it usually does.
How Stock Market Volatility Can Work For You.
If you are like many people and are putting money away into a 401(k) on a regular basis, volatility may allow you to make money on a specific investment over a period of time even if the investment itself doesn’t actually even increase in value. This is called dollar-cost averaging.
Let’s say for example you are buying Fund X which goes down the first 6 months of the year, then back up to even the next 6 months of the year. The fund ended the year breaking even, but since you were buying throughout the year, you may have ended up making money. This won’t make you rich overnight, but it can help take advantage of volatility and reduce the overall risk of your portfolio. You essentially outperformed your own investments, always a nice thing. On the other hand – if you sell during the downturn you have locked in your losses. Your money will never recover sitting in cash.
Consequently, people looking to accumulate long term wealth should really be looking for big volatility in the market. Always realize dips in the market are opportunities rather than risks. I love stock market volatility.
When Facing Investment Risk or Stock Market Volatility SANITY RULES:
To the layperson, the risk-volatility dynamic is counter-intuitive and can be pretty scary. I get that. And the greater the overall volatility of the market, the great larger propensity of investors left to their own devices to make emotional decisions that may cause them to underperform against their own investments and the overall market as a whole.
But that’s why it’s good to know that you don’t have to – and shouldn’t – face this alone. That’s why it’s so valuable to have a good financial planner on your side when facing investment risk or market volatility. Fiduciary Certified Financial Planners and professional stock investors get paid for facing these fears because so many others are not equipped, nor experienced enough, to face them and put the volatility to work.
Furthermore, the best fiduciary financial planners are more than just investment honchos. Giving real behavioral advice based on knowledge and experience is what the best of the best do on a daily basis. In addition to helping their clients keep their financial plans on track, they’re also instrumental in helping their clients keeping their sanity intact.
DRM Wealth Management President David Rae (The Fun Financial Planner) on CBS News again talking stock market volatility.
Live for Today, Plan for Tomorrow! Freaking out about stock market volatility will only hurt your investment returns.
David Rae shares with the CBS News What to do when the Stock Market Get Volatile.
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
― Warren Buffett– on Investment Risk
DAVID RAE, CFP®, AIF® is a Los Angeles-based retirement planning specialist with DRM Wealth Management. The fun financial planner has been helping people reach their financial goals for over a decade. He has published over 100 articles places like The Advocate, Forbes.com and the Huffington Post. Follow him on Twitter @davidraecfp, Facebook, or via his website, DavidRaeFP.com.