What’s the risk? As an investor, you need to know the answer to this question because once you know the risk, you can set yourself up to beat it.
Most investors think of a long bear market, a sudden market crash, or volatility as the risk.
Volatility is the price of admission in investing–you can’t take it away. Sure, It can be limited, and certainly work should be done through diversification to eliminate the chances of total loss; but volatility won’t ever disappear if you’re invested.
The good news is volatility is not the real risk.
Why people think volatility is the risk
It’s no wonder people equate risk with volatility. Making money feels good, but losing money feels twice as bad. It’s for this reason that people will be too conservative with their investments or avoid investing at all.
With this mindset the goal becomes preservation of your money—removing volatility to keep your dollars safe. But again, volatility is not the real risk.
What is the real risk
The real risk is losing your purchasing power. How do you lose your purchasing power? Inflation.
Inflation is called the silent killer. You know it’s there, but it happens slowly. Because of this, you don’t really feel it.
It’s like watching your children grow. As a parent, you see them every day. Sure, you know they’re growing, but it happens slowly. A visiting relative or an old photo will remind you just how much they’ve grown over time.
The same is true with inflation. Over the last 90 years, inflation has averaged around three percent–just enough to keep you from really paying attention. Just look at an old catalogue or check how much you paid for your first house, and you’ll see what three percent does over time.
Why it’s important to get this right
This is a vital distinction—volatility is not the risk; inflation is the risk. This needs to inform how we invest our dollars. Why is this important?
At this rate, the cost-of-living doubles about every 20 years.
Your kids age slowly, but after 20 years they go from a newborn to an adult. Think of this in the context of being a retiree. Is your income set to double over 20 years to keep up with inflation?
“Keeping your dollars safe” likely means losing value.
If you are concerned with minimizing volatility, chances are you aren’t exceeding the rate of inflation. You are keeping the same amount of dollars, but you are actually losing the value of those dollars.
Stocks are better at beating inflation than bonds and cash.
Before inflation, stocks have been twice as profitable as bonds over the long-term. After accounting for inflation, stocks have returned three times more than bonds.
Bonds are more susceptible to the harmful effects of inflation because their interest payments are fixed. Stocks, on the other hand, make great inflation hedges. Dividends have grown over five percent over time, trouncing the rate of inflation.
Volatility is a short-term distraction from what matters the most.
The best analogy for market volatility is a dog and its owner:
“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch.
But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”
The American economy is resiliently advancing over time. Volatility is simply a short-term distraction.
Don’t fall victim to volatility
While volatility is a short-term loss, there is one type of loss that you should avoid—permanent loss.
If you are properly diversified, only you can create permanent loss. Fear can cause you to make a temporary loss a permanent one by selling when the market is down. But if you recognize the real risk, and understand that volatility is not it, you can be better prepared to withstand whatever the market throws at you.