According to traditional thinking on Wall Street, the more an individual stock's price fluctuates day to day, the riskier it is. Most stock market participants crave a smooth ride on price, so any wide deviation from the upward trajectory is seen as a negative sign.
I view this belief to be extremely flawed, especially for the long-term investor. The primary concern should center on a company's qualitative characteristics first and foremost. The strong qualities will show through over the long term.
Let's find out why stock volatility does not necessarily equal high risk, and instead is often a featured that is required to attain market-beating returns.
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Up, down, up, down
The S&P 500, which is made up of the largest (and presumably safer) companies in the U.S., experiences meaningful drawdowns more often than you might think. According to data from brokerage firm Charles Schwab, the index went through a correction (a 10%-plus drop from a previous all-time high) in 11 of the years between 2000 and 2019. On the flip side, during that same 20-year period, the S&P 500 increased in all but five of those years.
Even with this inevitable roller coaster ride, the S&P 500 has historically appreciated at close to 10% per year on average. So, while volatility was definitely present, it ultimately didn't prevent long-term investors from seeing gains. And remember, these are some of the largest businesses in the world.
In the short term, the market is unpredictable and influenced by a million different variables. Over multiple years, however, quality and fundamentals are what matter most when it comes to a stock's performance.
Certainly, true business value doesn't move around much day-to-day, which is why volatility is nothing more than the market's mood at any particular time. With that being said, what risk really means is the chance of a permanent loss of capital, not how much the price bounces around. Even investing great Warren Buffett agrees with this definition, and it appears to have served him well.
An extremely volatile, but high-quality, stock
Roku (ROKU +1.74%) is a perfect example of a stock that is highly volatile, but also remarkably high-quality. According to its beta, which is a measure of how much the stock moves relative to the broader market, Roku's stock price is 76% more volatile than the S&P 500. The stock was up 17% in January, down 18% in March, up 32% in June, and is down 26% over the last month. But this does not necessarily mean it's risky.
ROKU data by YCharts
In fact, here are three reasons why Roku is actually an outstanding business, thus reducing its overall long-term risk for shareholders.
As one of the leaders in streaming entertainment, Roku gains from the shift away from cable TV. In 2015, there were 100 million U.S. households that had a cable-TV subscription. By 2025, that number is projected to fall to 60 million. And Roku, which generated revenue of $645 million in the last quarter (up 81% year over year), is a direct beneficiary of people cutting the cord.
Second, the business possesses powerful network effects on its platform. Roku connects viewers, content companies like Netflix and Walt Disney, and advertisers. It's a virtuous cycle that gets stronger over time.
That brings me to the last point. The value proposition for all these stakeholders is significant, something that only entrenches Roku's competitive position. Roku currently has 55.1 million active accounts that use the service to get access to all of their subscriptions in one easy-to-use interface. Content companies, particularly newer ones, want access to these customers, so they decide to partner with Roku. And big businesses, like Walmart, need to go where the eyeballs are to better target their ads.
Keep this in mind
Roku is getting better with each passing quarter, but many Wall Street analysts would probably view this business as quite risky due to its volatile stock price. Roku is better than the average S&P 500 company, and it has rewarded shareholders along the way, with its price skyrocketing 15-fold over the past five years.
Understand that investing in the stock market is the best tool for building long-term wealth, and being able to handle the ups and downs is just a part of the game. Stomaching volatility is a necessary ingredient to achieving market-beating returns over the long term. Always think about this the next time you're ready to invest in a stock, but are afraid of the volatility. It could end up being a huge winner like Roku.
