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Volatility is harmless…sometimes

While recently reading Against the Gods, I came across one of the best explanations I’ve ever heard for a topic that I spend a lot of time talking about: Volatility. The author (Peter Bernstein) quotes a fellow named Robert Jeffrey as saying that:

Volatility per se, be it related to weather, portfolio returns, or the timing of one’s newspaper delivery, is simply a benign statistical probability factor that tells us nothing about risk until coupled with a consequence.

I love that he compares the volatility of portfolio returns to the volatility of the timing of your morning newspaper delivery. That’s fantastic. 🙂

What he’s saying is that neither one has any inherent significance. However, depending upon your particular situation, either one of them might happen to be very important.

So just to spell it out, let’s run briefly through the effects of volatility on your investment success.

Still buying? If so, volatility is good.

As we’ve discussed before, if you’re still in the accumulation stage (i.e., you’re still buying investments), then volatility is actually a good thing. It amplifies the effect of dollar cost averaging, thereby allowing you to buy more shares for less money.

Only potential exception: You know yourself well enough to know that you’re in that category of people who tend to feel a strong desire to sell an investment immediately after a sharp decline in its market value. (And if you are in that group, my advice would be to learn about why that’s a terrible idea, rather than to invest primarily in non-volatile investments.)

Selling soon? If so, volatility can be ugly.

Logically enough, for investors who are regularly selling their investments (i.e., dollar cost averaging out of them), volatility has precisely the opposite effect. That is, it leads to your selling more shares for less money. And yes, that’s as bad as it sounds.

Of course, it’s still important for retired investors to maintain significant portions of their portfolio in equities in order to combat inflation.

In short:

Volatility itself is neither inherently good nor inherently bad. (I find it simultaneously fascinating and frustrating that people often state that it’s a bad thing.) Whether or not you should seek to avoid volatility depends entirely upon your current situation.

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Comments

  1. Thanks for (all of) your kind words, Miranda. 🙂

  2. Once again you write a great post that emphasizes that we are all at different places and have different investing needs. There is no one size fits all; we should consider our situations, and make decisions accordingly.

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