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Markets and Volatility

“Markets love volatility.”
-Christine Lagarde

equity market volatility

Editor’s note: In a timely follow-up to our last piece on fusion technology making fossil fuels obsolete, The Economist magazine (in its May 4, 2019 issue) published two articles on new developments in fusion reactors and the private sector’s role in providing funding for new projects.

Suppose I told you that I had a crystal ball and that it tells me that over the next 50 years the U.S. stock market (as defined by the S&P 500) was going to experience 11 bear markets (declines of at least 20% peak-to-trough), 3 of which would take the market down at least 50%. How would you position your portfolio? The correct answer: buy stocks!!! In the 50 years going back to the end of 1968, the market has experienced exactly that history, yet $1000 invested in the market at the end of 1968 would have grown to over $115,000 today.

In reality, most portfolios are not constituted of one investment made a long time ago, but rather consist of the growth of a series of past (and continuing) investments. How has volatility affected such a “real-world” strategy? Consider the following: suppose you invested $100 in the S&P 500 at the end of 1968 and added $100 each quarter. Call this Strategy A. Compare this to Strategy B of investing $100 at the end of 1968 (and adding $100 each quarter) in a hypothetical market that rose exactly the same amount each quarter (that is, experienced zero volatility) and had exactly the same total return as the S&P 500 over the 50-year period. Which strategy is superior? To listen to market pundits and commentators constantly lament market volatility, you would be forgiven for choosing Strategy B.

In fact, Strategy A outperforms B by over 45% in total! The $100 in the real market (Strategy A) would have grown to $234,382 vs. $161,235 for the no vol market (ignoring dividends which we’ll assume are the same in each case). The simple reason is that it pays to “buy low” during and after bear markets.

It is amazing how many investors don’t understand this, even purported “intelligent” ones. The lesson is also simple: invest as much as you can in the market (that is, the whole market – don’t try and pick winners and losers; we’ll have more on this in a future piece), maintain enough cash or other short-term investments to meet your liquidity needs, turn off the TV and throw away the market newsletters (certainly don’t pay for them!), and enjoy your summer. Ms. Lagarde got it only half right, markets do indeed love volatility, but investors should too!

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