Retirement investors want to grow their portfolios. They want that growth to come from steady capital appreciation — that is, higher stock prices.
What they don’t want is “volatility,” the movement of stock prices both up and down. The tendency is to equate volatility with risk, and risk with loss.
Let’s break that down a bit. Volatility is not risk. Rather, it’s the relative movement of stock prices up and down over time. That is all.
Some stocks move up and down more frequently than others. Some move in broader percentage swings than others. Frequency and breadth of price movement can make a stock seem “risky” compared to those that move slowly and steadily higher.
Yet you need those roller coaster stocks in your portfolio. They often represent the future of the economy, the small-cap stocks of companies just starting out, taking on problems from fresh angles, at times inventing the economy we will live in the decades ahead.
Some will profit wildly. Some will collapse and die. That’s capitalism. Without that, the whole world would move at the snail’s pace of tried-and-true older companies that were once the groundbreaking startups.
Volatility is not risk, if you diversify properly. Owning exposure to small-caps through an index fund gives you a grip on our future economy and its rewards, yet it doesn’t expose you to the immense risk of betting on just two or three companies, any one of which could be crushed by competitors.
You can smooth out volatility, too, by owning a variety of stocks, making small-cap exposure just part of the overall picture. Holding slower moving blue-chips stocks often means collecting nice dividends.
When small-caps dip, reinvested dividends are like rocket fuel, allowing you to buy more shares at a cheaper price. When you rebalance a portfolio, the same thing happens. Cash is distributed across your investments, including small caps if they are temporarily bid down.
Risk is not volatility. Risk is selling out when prices fall. Risk is your emotional reaction to volatility. If you can ignore the stock market completely, that risk falls to zero.
Again, diversification helps. Owning hundreds of small-cap stocks in an index fund means your exposure to any given single company is not meaningful.
Less concentration means less risk of emotional overreaction. In the end, you protect yourself not by ignorance but by choosing the side of limited emotional liability. A portfolio process helps you get there consistently and inexpensively.
Over the years, your portfolio will rise and fall in value. Early on, stock price declines are a chance to increase your position at a bargain price. As you near retirement, you will own less stock overall and be less exposed to that volatility.
Less volatility late in life equals less emotional risk, and that helps you retire with more.