After many years of a steady upward climb stock investors in October finally got a taste of stock market volatility — rapid moves up and down in valuation.
Some took it in stride. Some probably solid in panic, only to buy back in a few days later.
So what’s the right way to think about volatility? Think about driving.
Imagine you have your pick of automobiles for an afternoon drive. One is a family minivan, one is a sleek but underpowered sedan, and one is a Formula 1 race car.
You also have your pick of conditions: Sunny day, flat road. Curvy mountain road. Or a pro track with high banks.
Stocks and bonds are a lot like this. Some investments are a family minivan on a flat, sunny road. They chug along and demand almost nothing of you as a driver. Your biggest risk is falling asleep at the wheel.
You will get where you are going but the minivan tops out at 55 mph — a good choice if getting there safely is your goal.
Some are the sleek sedan. You look good behind the wheel. It’s fun to drive that curvy mountain road. You might have some close calls here and there but nothing really life threatening.
And some are the Formula 1 car. Even on a professional track you better know what you’re doing before you jump in and slam on the accelerator. A crash would mean a near-death experience.
In this example, bonds are the family minivan, broadly owned consumer and industrial stocks are the sedan, and the Formula 1 car is that small number of highly speculative, bets-on-the-future type stocks — IPOs and so forth.
The problem with overall market volatility is that a lot of people get behind the wheel of the race car and act like they’re in a minivan. So long as the track is smooth and flat, they think, nothing can go wrong.
The they hit the curve and things go wrong. Sometimes really wrong.
A lot of investors would better served to think hard about what vehicle they want to ride in and why. Do they want the slow ride that’s safe, or the fast ride that’s risky?
In their heart of hearts, people want safe with a dash of excitement. So most people go for the sedan. And that’s why most people own big company stocks, the kind you find in the S&P 500 Index.
That’s not to say that bonds or small stocks are not worthwhile. In fact, the most powerful way to invest is to use a portfolio, to build a hybrid that has the minivan’s safety, the sedan’s power, and the Formula car’s speed.
Owning bonds, big stocks and small stocks can provide a good balance of all three experiences. When a market panic moment ensues, you feel okay about it because you own at least some bonds.
When stocks take off again you don’t feel like you’re missing it because you have at least some of those small, fast-moving stocks.
But, mostly, you’re along for the ride in the middle ground, broad stock market exposure that is the heart of a long-term portfolio.
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