Volatility Is Your Friend

After a tough week for stocks to start December, the market has now declined by over 10% since its late September highs.  Referred to as a "correction," a decline of -10% is quite common as shown above in Exhibit 1.  Going back to 1979, at some point within the year, the US stock market (Russell 3000 Index) fell by at least 10% almost every year.  What we're currently experiencing is completely normal. In some cases (2002 and 2008, for example), the losses intensified before markets eventually recovered.  Typically, however, corrections don't go any further; over the 1979-2017 period, only 7 years saw a decline of greater than -20% (less than 1 in 5) that we typically label a "bear market."  

Whenever the market becomes erratic it's natural for investors to ask "why put up with all of this volatility?"  Because it's the surest path to earning the high long-term returns you probably need to achieve your most important lifetime financial goals.  Over the 1979-2017 period, the Russell 3000 Index returned +12.0% per year, $1 grew to over $81.  Over the same period, inflation (CPI) averaged just 3.4%.  Compare this result to the return on the much less volatile One-Year Treasury Note Index -- its returns exceeded inflation by only 2% per year (+5.4%) and turned $1 into just $8.  Having a considerable percent of your savings compounding at over 8% per year more than inflation as opposed to 2% makes achieving your goals and aspirations much easier.

As a long-term investor, you should understand that volatility is a necessary part of a successful investment experience.  But you should also realize that diversifying broadly is a way to potentially achieve a higher rate of return without significantly greater volatility.  The chart below shows that the globally diversified, small/value "tilted" DFA Equity Balanced Strategy Index (100% stocks) propelled $1 to over $165 from 1979-2017, more than double the growth of the Russell 3000 Index, due to a return of +14% per year.  But this result came with 0.2% less monthly volatility than the US Market!  

As a long-term investor, volatility is your friend.  To avoid it is to significantly reduce your long-term expected returns and potentially compromise the chances of achieving your goals.  While volatility shouldn't be avoided, it can be managed through broad portfolio diversification.  This approach won't squeeze all the short-term gyrations out of a portfolio but it will give you a better chance to get the highest returns possible for the risk you take.

______________________________________________________