What scares new investors most about putting their money into the stock market? Most of them would probably point to the way stock prices bounce around like a ping-pong ball. It seems like nearly every day, shares of some large company fall sharply for any of a host of reasons: failing to meet expectations of earnings, news of impending legal or regulatory action, or the need to restate financial results from earlier quarters. Whether it's Ford
Reducing total returns
High levels of volatility can reduce the total return of your portfolio over time. For instance, consider two different portfolios. One portfolio rises 10% in value each and every year without any deviation, while the other rises 20% in value half of the time and stays flat the other half. At first glance, you might believe that the overall return of these portfolios over time would be just about the same. However, the restraining effect of the flat years outweighs the higher return in the good years, and over longer periods of time, the stable growth portfolio gains value more quickly. At the end of 30 years, the stable growth portfolio will be worth more than 13% more than the volatile portfolio.
The more volatile the portfolio, the greater the impact on its return. If you consider a third portfolio that has annual returns of 30%, 10%, and -10% each year over multiple three-year periods, the same calculations over a 30-year span leave the more volatile portfolio worth almost 30% less than the portfolio that grows 10% every year.
For another angle on this dilemma, compare the average returns of portfolios with different volatility. Your initial impression might be that each of the three portfolios above would have an average return of 10%. However, when you use geometric averaging, the final results indicate that while the stable growth portfolio returns an average of 10% annually, the most volatile portfolio's average annual return is just 8.77%. Even though this seems like a relatively small difference, the reduction in compound interest over long periods of time can be huge.
Providing buying opportunities
When you focus on the stock market as a whole, it's easy to lose sight of the fact that market averages and popular indices represent aggregate measures of market performance. Just because a given index moves in a particular way doesn't mean that every single stock making up that index moves in the same way. For instance, even as the Dow has reached record highs in past weeks, Dow components Coca-Cola
Without volatility, the timing of stock purchases would make absolutely no difference. As long as you picked an investment with a positive return, buying low and selling high would be a sure thing; you could count on your stock rising a few cents every day, and you could simply sell whenever you needed the money.
In reality, the existence of volatility gives investors opportunities to take advantage of price drops driven by irrational reactions to new information. The foundation of value-based investing involves buying stocks when their market prices are lower than their intrinsic value, and avoiding them when irrational exuberance carries stock prices to unsustainable highs. Of course, this is easier said than done, since you can never be absolutely sure of a stock's exact intrinsic value, or know whether a beaten-down stock price reflects an emotional overreaction or serious bad news.
To take full advantage of volatility, you must time the market accurately -- a tricky feat for ordinary investors. However, techniques like dollar-cost averaging offer a simple way to benefit from volatility by changing purchase amounts based on prevailing prices.
Diversifying to reduce volatility
Nevertheless, the best solution for most investors is to minimize the effects of volatility. That's where diversification comes in handy. Theoretically, if you could find two investments that always moved in the opposite direction from each other, you could eliminate the volatility in the returns of each individual investment.
For example, consider two investments, both of which either return 20% or 0% each year, but which never move in the same direction; when one returns 20%, the other always returns 0%. Taken separately, if you were to choose either investment alone, your average return would be less than 10%, as was discussed above. However, if you invested half of your money in each investment, you would always earn a total of 10% each year, and your overall portfolio's growth would be stable and unhindered by volatility.
In the real world, you won't find assets that behave this way. In statistical terms, no two asset classes ever have returns that behave so precisely. However, by choosing from a variety of different types of investments that don't behave in exactly the same way, you can reduce your potential downside risk and increase the stability of your portfolio's value.
No investor likes to see the value of their investments plummet. By being aware of volatility and taking steps to reduce it, while also making the most of the opportunities it brings, you can not only improve your investment returns, but also avoid the anxiety of dramatic movements in your net worth.
Further fluctuation-free Foolishness:
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Like a kid looking up at a roller coaster, Fool contributor Dan Caplinger always thinks volatility looks exciting until he's looking down from the top. He doesn't own shares of any of the companies mentioned in this article. Pfizer and Coca-Cola are Motley Fool Inside Value picks. The Fool's disclosure policy will keep you steady.