The Investor Community’s Fear of Volatility

When I spent one summer teaching a math course to elementary school students that had a personal finance component to it, I was dissatisfied with the type of material that I was assigned to teach. I was supposed to have students answer True/False questions with information like the following: T/F Bonds are safer than stocks. The correct answer, according to the handout, is bonds under the theory that the relatively less volatility is proof of superior safety.

I understand that you have to start somewhere, and introductory information should be easy to grasp. Oversimplification comes with the territory. The problem is that the introductory information has the greatest consequences of you learn it wrong–initial impressions are the hardest to overcome because they serve as the foundation base–and can’t be weeded out as easily as false information acquired deep into a professional career when you already have a process for correcting erroneous information that slips into your mind.

It seems to me that successful investing comes down to tolerating, and ideally embracing, the volatility in the price of things that you own or prospectively own. This can be done by: (1) recognizing the pervasive effects of recency bias so that you do not let it cloud your own judgment; (2) understand what you own so that you do not substitute prevailing market prices for actual assessments of long-term value; (3) own assets that produce cash, as money getting deposited into your account can countervail short-term irrationality; and (4) understand stock market and individual company histories so that you do not treat usual variances as once-in-six-hundred-year events.

For a true buy-and-hold investor, there has only been one ten-year period when the investor had less money than at the start of the decade. This was the 1928-1938 period in which investment turns amounted to -1.3% annualized. A $1,000 investment in U.S. stocks in 1928 would have given you a $877 net worth by 1938. A lump-sum investment in 1928 would also have spawned the worst twenty-year period in stock market history, as 1928-1948 returns were only 2.5% annualized. A $1,000 investment in 1928 would have only become $1,638 by 1948.

Before you despair, you should keep in mind that the best defense against these type of twenty-year returns is to display discipline when selecting stocks. When people discuss the poor returns of the 1930s and 1940s stock market, it is often neglected in the discussion that some of the poor performance was a result of the unjustified gains in the 1920s.

On January 1st, 1920, the Dow Jones stood at 72. It consisted of coal, textile, and railroad stocks. By the time October 28, 1929 came around, the Dow Jones had added stocks from the railroad, radio, and consumer appliance sectors that were trading in the vicinity of 75x earnings. This dragged the Dow Jones valuation up to 381, without taking into account the effects of dividends. The index itself quintupled in stock prices in under ten years on the eve of the crash. The only sector not trading above a cyclically adjusted P/E ratio was the oil sector majority-owned by the Rockefellers.
This isn’t to diminish the hardships of the Great Depression–there is a justified reason for why America’s sturdiest citizens drop their voices to a whisper when they talk about daily life during the Depression–but to recognize the contributing effects of overvaluation in explaining some of the poor performance that followed.

If we used 1924 as our starting reference point in evaluating the 1930s and 1940s (rather than the eve of the Depression in 1929), then we will see fifteen and twenty-five year returns of 5.0% annualized and 5.5% annualized, respectively. Those are not great absolute returns, but given that it represents the longest extended dark hour in American history, they should be a cause for encouragement. Nothing beats long-time horizons mixed with reasonable (or better) starting valuations.

That’s why the overwhelming focus of my financial writings is common stocks rather than bonds. Benjamin Graham spent a lot of time discussing preferred stocks and bond allocations. He was fanatically focused on bankruptcy distribution estimates, a practice that has partially made Marty Whitman and Seth Klarman a lot of money. I’m less interested in that aspect of investing because most companies have fewer assets to distribute today compared to days past due to the trend toward asset-light businesses, and a basket of distressed common stocks tends to beat a basket of distressed bonds because of the nature of geometric compounding–owning something like Pier 1 Imports that increases 21x fold coming out of a recession can make you richer even if the common stocks that you own go bankrupt.

Also, it is worth noting that there has never been a thirty-year period when stocks did not give a positive return, whereas bonds and T-bills have delivered negative returns over a thirty-year time frame. That is why I cannot endorse the blanket generality that “bonds are safer than stocks.” From 1928 to 1958, stocks returned 2.6%. That was the worst. Bonds, meanwhile, once had a thirty-year period of -2.0% annual returns and T-Bills once had a period of -1.8% returns.

Since the founding of America, stocks have outperformed bonds in 99.6% of measurable thirty-year periods. Here is the cocktail party bit of trivia: From 1831 to 1861, bonds edged out stocks by 0.2% annualized. Other than that, it’s never happened. From 1830 to 1860, stocks win. From 1832 to 1862, stocks. A lump-sum investor in 1831, holding for thirty years, is the condition in American history when a long-term bond investor beat a long-term stock investor.

But volatility prevents investors from acting rationally based on this information. Over a five-year period, three out of five years are positive based on stock market history (that is why this current stock market of seven years of advancing gains is historically unusual). In four during each decade, someone owning stocks will underperform someone marking their money in bonds because stock prices will go down. It is the magnitude of victory during those six up years that provide for the outperformance.

The short-term probability of experiencing loss on paper is the worst enemy of the investor. It prevents otherwise intelligent people from getting rich through the accumulation of passive wealth in a basket of stocks. The silver lining is that this emotional tendency does provided the irrationality in the market that it makes it possible to get good deals. That said, I would much prefer to make money from earnings growth compared to P/E changes because the former benefits from building something whereas the latter benefits from taking advantage of someone else. Favorable life results in the investment markets are entirely conditioned upon tolerating possibly extreme fluctuations in net worth, and it is wise to develop a strategy that takes your own emotional tolerance into account so that you do not forfeit wealth by selling low.