A thousands points up one day, a thousand points down the next. The return of volatility to the major U.S. stock indexes is unnerving for sure.
But that doesn’t mean it’s a bad thing. In fact, volatility can be a good thing for the long-term investor.
Volatility is nothing more than the up and down movement in the valuation of an investment. The change in valuation is meaningless until you sell, but nobody likes to see red in their portfolio, naturally.
Generally speaking, volatile investments tend to do better over the long run. Stocks of small companies, for instance, are usually more volatile than large company stocks.
Nevertheless, those small company stocks offer better returns over long periods of time. If you can handle the price changes, you’ll do better.
In a portfolio of stocks and bonds there will be some investments that are naturally more volatile than others. Bonds are relatively predictable, for instance, compared to most stocks.
That’s where rebalancing comes in. If your stock holdings go up in value you have an opportunity to sell some of those stocks.
The money can be distributed anywhere you like, but usually you would buy stocks that had not appreciated as much, or more bonds.
In time, you may find that bonds do best over a given period of time. In that case you rebalance by selling some of those bonds holdings in order to buy stocks.
In a portfolio that exhibits no volatility, these rebalancing efforts offer less upside to your portfolio.
In fact, a portfolio in which all of the investments appreciate at the same pace should give one pause. What happens if they all decline at the same time, too?
Years of data, however, strongly suggest that the more likely outcome is that investments grow at different rates of speed.
Over longer periods, however, you can expect most diversified investments bend toward a long-term average annualized return.
Academics call this “reversion to the mean.”
Put another way, stocks return a certain amount most of the time. Bonds return a certain amount most of the time.
When they diverge from this typical long-term rate of return, the most likely turn of events is for each to move back toward that average expected rate of return.
When they move away from their mean, upward or downward, that’s volatility.
It’s also a chance to take some gains and reinvest by rebalancing, thereby getting a bit more turn than you would otherwise in your portfolio.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.