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Why Volatility Matters

If you walk into your broker or adviser's office, and he or she proceeds to pull an "Ibbotson" chart from their desk drawer to explain why you should stay the course in this volatile market - repeat the following: "volatility matters."

A little background: The "Ibbotson" chart is a graph representing historical market performance (as calculated by Ibbotson Associates) for various asset classes (large company stocks, small company stocks, long-term government bonds, treasury bills and inflation) over the period from 1925 to the present. In a nutshell, the graph reinforces the notion that the highest returns - albeit over a relatively lengthy period of time - accrue to stocks, rather than bonds. For example, $1.00 invested in "small company stocks" in 1925 would have grown to over $6,402.23 by 2000. By comparison, the same $1.00 invested in treasury bills over the same period would have grown to only $16.56. Pointing to the chart, your adviser is likely to ask (somewhat more diplomatically): "Why would anyone but an idiot want to own bonds, versus stocks, when history clearly shows stocks always earn more"?

Overlook for a moment the factual inaccuracies of the results (you'll have to trust me on this one) and focus JUST on the appearance of the lines - particularly the lines representing the returns for stocks. What you're looking at is a picture of the "volatility" of the returns for those assets. The line representing treasury bills will be fairly steady, and generally upward-sloping. You might say it's rather gentle. The line(s) representing stocks will be jagged, and will show declines periodicallynearly as often as they show increases. You might say they resemble an EKG.

If you ignore these discrete patterns, and instead focus only on the general upward slope to the line (which is what your adviser is asking you to do), the EKG may well be your own! Just ask someone who had their entire nest egg invested in the stock market over the past several years. The physical discomfort they're feeling is what's illustrated by the patterns on the chart. Volatility matters! Why? Because volatility in the timing and severity of the distribution of returns that an investor earns in the near- and intermediate-term can erode so much principal that recovery (even to break-even) becomes difficult or impossible.

Consider for a moment that if you were to lose 25% of the value of your portfolio in any one year (sound familiar?), you would need to earn 33% the following year just to break even.Lose 50% (I know you're out there!) and you have to gain 100%. That's a tall order for just about any portfolio, even spread over several years. Are there any out there among you who believe that kind of stock market performance is likely in the coming years?

So what's an investor to do? Focus on the fundamentals. The secret to investing (as in much of life) is found in the balance. Don't put all of your eggs in the small stocks basket expecting to turn your $1.00 into $6,402.23. Diversify. Allocate some of your investment to treasury bills, and a portion to long-term government bonds. When done properly (see me, we'll talk), the result will be a portfolio that exhibits the best characteristics that all of these assets have to offer. Your "line" will still slope upward over time, but with a fraction of the overall volatility -and with a greatly reduced probability of serious capital loss. Now aren't you feeling better already?


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