The Value Of Volatility

When the market falls, especially after a strong upward run (4+ years in this case), I think it’s worthwhile to remind everyone about the value of volatility. To keep it simple, let’s just think about a simple portfolio containing all US stocks and no bonds. This is what I would consider to be an extremely aggressive portfolio, one that would be hit very hard by a bear market like we had from late 2007 to 2009. Let’s look at 2 cases, with the stock index in both cases shown in the graph below:

Case 1: Reality (Volatile Market) – Using the actual performance of US Stocks from late 2007 to the end of 2012, suppose you had a $100k portfolio in September of 2007, just before stocks peaked and started heading lower. Your financial plan for retirement called for $1k per month contributions consistently (think of this as your 401k for example). The market tanks, losing almost 50 of its value by March 2009, and then slowly comes back to surpass where it started. By the end of 2012, you would have amassed a sum of $196,024.60. That’s your original $100k + $63k in contributions + over $33k in gains.

Case 2: “Ideal” (Market Never Falls) – In this case, we’ll pretend that the stock market moved in a slow straight line starting at the same value as in Case 1 and ending at the same value as in Case 1, but with no volatility. It never had a losing month and just kept slowly increasing. Let’s start with the same $100k and add the same $1k per month. This would feel much more comfortable. You could look at your statement and see constant progress… slow and steady. No sweating, no heartburn, no temptation to sell or alter your contributions. I call this the “ideal” case in quotes, but it’s actually far from ideal. In this scenario, you would have ended 2012 with $180,931.30. Again, your original $100k + $63k in contributions + ~$21k in gains. That’s only 2/3rds of the gain with the volatile portfolio, simply because you never get to add your $1k per month at lower prices.

The moral of the story here is that if you’re adding to your portfolio regularly, you really should be hoping for the market to fall from time to time, not rise, so that you can buy at lower prices. Sure, you want the market to rise right before you need to withdraw money, but until then, the lower it goes (a la March 2009), the worse it will feel, but the better it will be long-term. Volatility is the real “ideal” for the long-term investor.

5 thoughts on “The Value Of Volatility

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