Why Market Volatility is a Good Thing for Investors
“You are my heart, my life, my one and only thought.”
Although best known for writing Sherlock Holmes, Arthur Conan Doyle also wrote The White Company. In this book, he described one character’s affection for another with that beautiful thought.
That was in 1891.
Now, it’s 2018. Instead of speaking like that to your beloved, sometimes it’s OK to simply say “you are my bitch.”
“My bitch” is “a term of endearment, which, when used in the right context, is the highest form of compliment.”
The times have changed. And I have not kept up with the times in many ways. But both views describe my feelings for volatility.
Volatility in financial markets is “my heart, my life, my one and only thought.” Or, volatility is my bitch.
Volatility Isn’t the Same as Risk
It’s important to understand that many investment professionals don’t understand what volatility is.
Many believe volatility is synonymous with risk. Financial planners often use the words interchangeably. But they’re wrong.
Risk is bad, and volatility is good. Calling a market volatile is the highest form of compliment.
In 1891, I would’ve said volatility is my one and only thought. In modern terms, that means volatility is my bitch.
We need a better definition of risk. To me, risk is the chance that money won’t be there when I need it. I learned risk was intolerable under any conditions when I managed money.
In 2009, I met potential clients who lost so much money in the bear market that they were delaying retirement. I met people who couldn’t help their children or grandchildren like they wanted.
Some were surprised by their losses. They said their financial adviser assured them that their portfolio was low-risk. A few knew the annualized standard deviation of returns and thought they understood risk.
Well, it is true that the standard deviation of annual returns for the S&P 500 Index is about 17%. But that doesn’t really mean anything. This shows investors almost always think of risk in abstract terms.
In real terms, risk means delaying retirement or telling your children you wish you could help with the down payment on their home, but you just can’t afford to right now.
Risk is the possibility of a life-changing event. And investors must always avoid risk. I’ll talk about that more in future articles.
Volatility Is Good
On the other hand, volatility is an opportunity to improve your life.
Volatility is simply a market move. It can be low or high. It can be up or down. Volatility is what’s required to increase wealth.
To see why volatility is different than risk, think about that popular definition using standard deviations. If annualized volatility is 17%, a two standard deviation move means prices change by 34%.
If you own an index fund that goes down by 34%, you’re sad. A 34% gain makes you happy. Your reaction is different, but the volatility is the same.
In this case, we welcome upside volatility while wanting to avoid downside volatility.
That’s the problem with thinking of volatility as risk. We can’t make money without volatility.
Unfortunately, volatility is relatively rare. The chart below shows daily volatility of the Dow Jones Industrial Average since 1900. On an average day, the Dow gains 0.03%.
While that small change builds wealth over time, occasionally there is extreme volatility.
The Dow moved more than 10% on 10 separate days — seven gains and three losses. Catching extreme volatility can build wealth quickly.
To benefit from upside volatility, we could buy a stock or a fund that tracks the stock market. To benefit from downside volatility, we can sell a stock short.
We could also use options to benefit from an up or down move.
Call options increase in value when prices rise. Put options increase in value when prices fall.
An added benefit of options is that they allow us to precisely manage the size of potential losses in dollar terms.
Yet many investors ignore options because they think they’re risky. Of course, many investors use the wrong definition of risk.
I Welcome Volatility
The bottom line is all investors need to question their assumptions.
We all need to think about what we want from the markets. Then we need to use the right strategy to get what we want.
None of this has anything to do with risk. That’s a separate discussion.
When you separate risk and volatility, you understand volatility is simply the tool we need to increase wealth.
I welcome volatility as “my heart, my life, my one and only thought.” Or, in the vernacular of today’s youth: Volatility is my bitch.
Michael Carr, CMT, CFTe
Editor, Peak Velocity Trader