It’s widely understood that to achieve higher returns, you must be willing to accept higher levels of volatility.
We’re often conditioned to view volatility negatively, especially when it causes our investments to drop in value. We accept it though, because it is the cost we must endure in order to generate high long-term returns.
But what if even this is a misconception? What if short-term price reductions were actually a good thing for those investing on a regular basis?
A cost, or a benefit?
Imagine you have $250 per week to invest in a share worth $1. You have two choices of investment:
- One returns 8% p.a. in a completely linear fashion. That is, there is zero volatility.
- The other share also returns 8% over the entire year. However, this share has three market drops each year of 15%, recovering after five weeks.
At the end of the year each share has returned the same 8%. As you’ll see below, regular investing can lead to a higher total portfolio return, even if the share price return remains constant. This is because it doesn’t factor in the advantage of buying at lower prices during market dips.
*8% p.a. return is applied and compounded weekly
The chart above shows that the more volatile share results in a higher portfolio balance at the end of the year. The portfolio with the linear returning share ended with $13,523 and the volatile share with $14,210.
The simple reason for this is that when an asset drops in value, provided the ongoing investment deposits continue, you are essentially buying it at a discount. This means that for $250 per week you can buy more units of shares.
How this works in practice is outlined below:
- Let’s say you have $250 to invest in a company with a share price worth $1. This would buy you 250 shares.
- Right before you make your investment, the share price drops to $0.50. You can now buy 500 shares.
- If this share eventually recovers to again be worth $1, your 500 shares would now be worth $500. This would represent a 100% return.
So the obvious question is, why not just only buy when prices are low and sell them again when they’re high?
The “buy low, sell high” strategy
Buying an asset when it’s low and then selling it again when it’s high sounds great on the surface. However, in practice it’s functionally impossible to do this over the long term with any certainty. Even the vast majority of professional money managers cannot reliably outperform the market average.
So, if we assume that one cannot reliably outperform the average market return, how does the average investor gain any benefit from the inherent volatility of shares?
Dollar Cost Averaging
Dollar cost averaging (DCA) is an investment strategy where you invest a fixed amount of money at regular intervals, regardless of market conditions.
The primary tenet of a DCA strategy is that you invest on the exact same regularity, whether it be weekly, monthly or otherwise. This ensures that your own biases of whether a share is too high or too low do not affect your regular investing schedule.
This means you will naturally continue to invest during periods of time where the asset is experiencing a market drop, thereby buying at a “discount”.
The effect of this can be seen below. Here we are comparing the same asset returns as chart one. The orange line represents investing $250 per week regardless of market conditions. The blue line shows what happens when you only invest during positive market periods.
So, when the market is down you would be saving your money to be used again when the market becomes positive.
The amount invested over this time period is the exact same, $13,000. The difference in returns is $728, or over 5%.
DCA removes the emotional decision making from investing. It is very easy to get caught up trying to time your investments correctly based on your own view of the market. This includes the decision to cease investing because the market has been going down recently.
After all, who wants to immediately see their investment lose value?
Real Life Data
The examples provided above are entirely unrealistic, there would never be two separate assets returning the exact same amount with two wildly different levels of volatility.
Nor would there be an asset with predictable and consistent volatility throughout any time period.
Volatility is just one of the prices we pay to generate higher returns, and it is distinctly separate from risk. Trying to outsmart the market and avoid volatility – by buying low and selling high – introduces actual risk. This approach increases the chance of losing potential returns by missing both the market downs and the ups.
A study by Dimensional examined the impact of missing the best-performing week, month, and quarter over a 25-year period in the Russell 3000 international shares index.
What they found was that if you missed the single best week of returns in that 25-year time period, you would have lost over 16% of your total return.
This week of returns was between the 21st and 28th of November 2008. Amidst the GFC market crash.
What is more important to understand though, is that the week prior to this (the 13th to 20th of November) the market had made a negative return of 12.16% in a single week.
So, the best returning week in an entire 25-year time period came at a time of extreme market volatility and uncertainty. It also succeeded a week in which the market had lost over 12 percent of its value.
This example displays the absolute impossibility of benefitting from stock market returns without needing to endure its inherent volatility. Be wary of those claiming that they can get one without the other.
You cannot have your cake and eat it too.
Summary
This article was written to shed more light on the ups and downs of investing. Your account balance going up and down with the market is a good thing, provided that you make sure you stick to your strategy, no matter the market conditions.
There will be organisations and media that attempt to profit from the fearmongering around the volatility of the stock market. You would do well to ignore it.
Embrace market volatility as a necessary part of achieving long-term returns. It’s not a barrier, but the very foundation of successful investing.
