Volatility will hurt stock returns only if you let it

Dave S. Gilreath, CFP

From the way talking heads and some advisors characterize market volatility, as a scourge for stocks, it’s understandable why many investors fear it as much as a case of long covid.

Volatility gives individual investors the heebie jeebies because they think it irretrievably damages stock portfolios.

There’s damage, all right. This damage comes not from volatility itself, but from many investors’ reaction to it.

Volatility s widely misunderstood. It’s when an investment varies widely in price over a relatively short period. Relatively stable prices mean low volatility. High volatility is when investments rapidly yo-yo up and down from one week, day, hour or minute to the next.

There’s always some volatility in the stock market. Equities and indexes rise or fall in jagged, not diagonal, lines on the chart. Though the market sometimes goes long periods without becoming herky jerky, high volatility is like rain. The question isn’t whether it will occur, but when.

Recently, market volatility registered an uptick. In mid-April, the S&P 500 index declined about 5%, but then bounced back a bit, ending the month down about 2%. As of this writing in the first week of May, major indexes were rising further.

Pacific period

This mild spate of volatility was a mere swell in the current, relatively pacific period that has set in since high volatility roiled the market in 2022.

Such low volatility is usually associated with high forward returns. Yet this connection isn’t really important to truly long-term investors, who can afford to be statistically aloof to such market indicators.

Historical trends indicate that the market probably won’t be particularly volatile the rest of the year. Presidential election years are usually positive for the market, and always when an incumbent is seeking re-election. In such years, the average total market pullback is 10%, compared with 14% in non-election years. So if historical patterns hold true, the rest of the year will be short on volatility and produce better-than-average gains.

But in any kind of year, volatility is mistakenly viewed as some kind of curse. Some investors are so afraid of it that their blood pressure varies inversely with the market’s movements.

Inured to volatility

However, some experienced investors are apparently inured to volatility. Nearly four in ten (39%) surveyed in 2023 said they don’t worry about it. A majority of millennial respondents said volatility keeps them up at night, compared with only 15% of older investors.

So for these older investors, volatility is less of a problem, probably because they’ve seen a lot more of it. If it’s always a potential factor and you account for it in your investing strategy, goes the implicit logic, volatility won’t be a problem.

Many investors make money off the stock market by ignoring transitory price fluctuations. Instead, they leverage long-term market performance, which historically has been up more than down over the ultra-long term. In other words, they wait and do nothing—a practice that’s anathema in American culture because we prize action and dynamism. Americans seem to live by the mantra, “Don’t just sit there, do something.” Like Superman, we want to save the day.

Yet significant wealth from the stock market has been accumulated by people who don’t do anything most of the time. Like Warren Buffett, they just wait for stocks to grow. As Buffett quipped, “Lethargy bordering on sloth remains the cornerstone of our investment style.”

Buffett’s phenomenal investing success shows that doing nothing can bring rich rewards. Yet the Oracle of Omaha has been known to actually do something amid high volatility—add shares of high-conviction stocks at low prices. Some individual investors do this, but studies have shown that most end up selling when volatility pushes values down. Unfortunately, they habitually buy high and sell low.

“If the investor fears price volatility, erroneously viewing it as a measure of risk,” says Buffett, “he [or she] may, ironically, end up doing some very risky things.”

Not the same as risk

Buffett laments that risk and volatility are conflated at business schools. “Volatility is far from synonymous with risk,” he says. “Popular formulas that equate the two terms lead students, investors and CEOs astray.”

Some individual investors have adopted Buffett’s uber long-term approach, but Buffett has become one of the world’s wealthiest individuals by taking it to a sagacious extreme, holding stocks for years or even decades.

Of course, it’s easier to be patient if, like Buffett, you’re fabulously wealthy and are paid to invest the money of a huge company like his, Berkshire Hathaway.

Most investors lack Buffett’s patience, in many cases because limited resources, expenses, life goals and retirement horizons dictate otherwise, sometimes forcing them into ill-timed selling. But even within the limits of their individual constraints, many individual investors churn their portfolios much more than necessary.

Holding stocks long-term isn’t a tough concept for most people to get their heads around. Yet it’s more easily said than done and requires great discipline. As Buffett said, investing is like dieting—simple to understand but hard accomplish.

Harnessing volatility for gain

Volatility can actually be used to strengthen portfolios. If properly harnessed by using options—essentially, market-traded bets that stocks will rise or fall within a setperiod—volatility can more than compensate for the declines of underlying assets by producing portfolio income. Thus, options can serve as a form of insurance.

Options trading is a complex undertaking best left to qualified advisors. One advisor strategy is to systematically overlay a program of options trading atop a major stock index, such as the S&P 500. This strategy has proved highly effective over long periods—e.g., 10 years—so it requires commitment from clients. For investors without advisors, there are various fund products (including exchange-traded funds or ETFs) that use this strategy.

Investors who can stomach volatility are able to take advantage of buying opportunities created when prices are pushed down by the rash selling of the fearful. Thus, they can build a portfolio more likely to grow over time.

Though volatility is different than risk, the two are similar in this sense: If you can’t stomach either one, you shouldn’t be in the stock market.

Dave S. Gilreath, CFP, is a founder and chief investment officer of Sheaff Brock Investment Advisors, an investment firm for individual investors, and Innovative Portfolios®, an institutional money management firm