There are two definitions for volatility.  The scientific one:  “The degree of variation of a trading price over time as measured by the standard deviation of logarithmic returns.”  Very few people know or understand what that means, but it doesn’t stop them from using the term.

Then there is the more common definition: “The liability to change rapidly and unpredictability, especially for the worse.”  This is closer to what most people think volatility means, with an emphasis on unpredictability and bad outcomes.

In October the stock market was volatile, plunging about 7% in one month.   Horrifying, because the stock market had not dropped more than 5% in any one month in almost four years.   Not however unpredictable, because in the past ten years prior to that, the market had a greater than 5% slide on average every 7.5 months.  

In fact, over the last 90 years, the standard deviation of the S&P has been ~20%, with an average return of ~9%. This means that on average, the market returned 9%, but in any single year, 68% of the time (one standard deviation) we could expect the return to be between 29% on the high end and -12% on the low end. So it should come as no surprise to us when the market goes up OR DOWN about 20% in a short period of time.  It’s what the market has always done.  Of course in years when the market goes up 20% without a correction nobody calls it volatile.  But, when it goes down 20%, even after years of great returns, it’s a disaster.  But it is not unexpected.  It is just a return to normal.

Why Are Markets Volatile?

When you buy a stock, you are effectively saying that you believe the company’s future earnings and dividends are worth the price that you are paying.   How far in the future?  For a true investor, very far!   Farther than next quarter, maybe a few decades.   Making projections like that is an inexact science.  The value of a company will fluctuate with changes in the economic climate, prospects for the industry and the overall success of the company. 

That’s the big picture, but overlaying that, is an army of speculators and traders trying to gain any advantage they can by anticipating news and exaggerating trends.  Today they are armed with computers and lightning fast trading systems, but interestingly not much has changed.  Except for the recent calm, the markets are no less or more volatile today than they were when stock prices were posted on a slate board under the buttonwood tree.

How could this be?  We have blocks of computers running the latest AI software that analyze every variable known to man to try and predict the future, but we are no more accurate at predicting the future than we were a century ago?   It appears that way because we still have earnings surprises, are blindsided by changes in the economy, and stocks move up and down on unexpected news the way they always have.

The answer is that markets are volatile because of people.  People tell the computers when to buy and sell and they still have the same fear and greed that they did a hundred years ago.  We may have better tools to measure the economy and better corporate disclosure, but that information ends up in the hands of people who have the same goals they always had; to maximize profits and minimize risks.

We put up with the volatility because over time stocks have the highest return of any investment class.  That return is about 8% to 10% annually over just about any decade, but not every decade, and certainly not every year.  If you want stability, buy a Treasury bill.  If you want a certain return, buy a bond.  That’s what those markets are for.  Stocks are for long term investing to maximize your return with relatively high volatility.  Every scheme that tries to make stocks into something they are not has failed.

Stocks for The Long Run

Jeromy Siegel wrote the modern primer on stock investing, Stocks for the Long Run.  It’s full of great facts and figures about the stock market but the title says it all.   Stocks are best suited for long term investing.  Why?  VOLATILITY. Time is the only way to tame volatility and turn what could be a totally unpredictable crap shoot into a relatively predicable investment.

Let’s say you have two investment choices.  One has an average compounded rate of return of 9% for the past hundred years.  The best year was up 66% and the worse was minus 44%.  The odds are in your favor because you can expect a positive annual return about 75% of the time, but 25% of the time you will lose, sometimes a lot. You’d say: “Interesting speculation instead of a lottery ticket, but hardly anything I’d use as an investment.”

Or, you could have an investment with the same 9% average rate of return, but a maximum return of 17% and a worse return of minus 4% for the past century, leaving you with a better than 90% chance of a positive return in any one year.  You would probably take the second option because it’s a great return and a risk you can live with.   As the chart shows, Option 1 is what happens if you have a one year holding period, and Option 2 is for ten years.  It’s all about TIME.

It’s not about making market predictions causing you to buy and sells stocks, putting a tax drain on your portfolio and cutting your time, thus adding to risk.  It’s not about picking only stocks that have the best current earnings momentum, because ten years is too long a time to expect that momentum to continue.  It’s not about picking stocks with just the highest dividends because the indexes assume dividends get reinvested without paying taxes or transaction costs.  The only way to do that is to have the company reinvest its earnings for us and pay just a modest dividend. 

The best and only proven way to lower volatility is to buy and hold stocks for a long period of time.

Learning to Love Volatility

Buffett’s Mr. Market Story:  Let’s say you own a great business with a partner called Mr. Market who every day offers to buy or sell a portion of his share of the business at a price you can accept or refuse.   Given that it is a profitable and fairly stable business, if Mr. Market was a rational man, the price he asked or offered daily would be fairly stable, reflecting the long term earnings potential of the business.  Alas Mr. Market is often irrational.  When things are going well, he becomes euphoric, and offers to buy you out at a price you know is well in excess of what other companies can be bought for.   When things are bad, he becomes so depressed he offers you his shares at a fraction of what he was willing to pay just a few months earlier.  

What a terrible partner to have!  Who would do business with such a mad man?   You would, because he will make you wealthier than if he was just calm and rational, lacking volatility.  Over time, the shares you bought from Mr. Market at a huge discount to their normal price will appreciate faster than if they had been bought at full price.   And occasionally, Mr. Market will have paid too much for your shares, leaving you to find better return on your money or at least wait for better opportunity to buy from the schizophrenic Mr. Market.

If you believe that you have a portfolio of great companies that combined will offer relatively stable growth over a reasonable period of time, disparities in prices (volatility) can be used to your advantage. 

Is Volatility a Fair Measure of Risk?

Volatility doesn’t just apply to the overall stock market.  For many investors it is also the most important input in determining whether or not to make an individual stock investment.  Modern portfolio theory postulates that investors should seek out the greatest return while taking the least amount of risk.  According to the theory, risk is measured by an investment’s historical standard deviation from the average, or its “volatility”.  Stocks that fluctuate most are assumed to be more risky based on this theory, and therefore require a higher expected rate of return for you to invest in them.

Intuitively this makes sense.  It’s harder to lose money when you buy a company whose stock fluctuates less.  But there are two flaws with this reasoning. The first is that future risk isn’t a quantifiable thing, because the future is unknown.  Standard deviation is a historical metric that incorporates only one variable and that is past price fluctuation.  It tells us nothing about what will happen in the future, unless we believe that the future will always replicate the past. 

Take for example General Mills and Campbell’s, who have had relatively low historical volatility but are down 30-40% over the last two years during a neutral equity market.  If you bought these companies looking for a good dividend and stable equity price movements because that is how they performed in the past, you got something very different.

Which brings us to the second major flaw.  As the decline in General Mills stock price accelerated, its calculated standard deviation increased.  It went from a high quality, low volatility consumer stock at $71/share to a low quality, higher volatility stock at $40/share.  According to the theory, General Mills is now more “risky” at $40 then it was at $71, and those that were comfortable buying it at the higher price are likely to avoid it at the lower one.  This major flaw in volatility theory is what makes what we do at Compass possible.   We look for bargains based on something more than just past performance. 

Why Compass Loves Volatility

The last few years presented a great challenge for value investors because of a lack of volatility.  The FAANGs, this generation’s leaders of tomorrow, steadily carried the markets to new highs with no real corrections and very little rotation between industry groups.  The FAANGs are fantastic companies, but at some point “investors” no longer cared about their valuations, they were simply riding momentum.  When valuations no longer matter, it requires great patience from investors who believe that you should not pay more for a company than what it is intrinsically worth, even if the stock goes up every day.  

When the music stops and “investors” grow uncertain about future prospects, value managers’ eyes light up.  While greed can drive short-term movements in stocks, it is the ability to take advantage of fear that can drive long-term gains.  Alas, there can be no bargains without a sell-off, and no overvaluations without euphoria.  In times of volatility, we tend to see a return to value over momentum.  A return to investing, rather than simply believing, “It’s a great company and it’s taking over the world”, so the stock can only go up.   

Wishful thinking can last for months, even years, but when volatility returns, opportunities for fundamentals based long-term investing present themselves when valuations of beaten down stocks become compelling.   We think we are very close to that moment now.   While the indexes have only about a 10% correction, most of the stocks in the Dow and the S&P 500 have had a greater than 20% correction.   The correction has been disguised by the handful of big cap stocks that dominate the market cap weighted indexes.  That gives us plenty of opportunities to happily shop for bargains.

Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.

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