Volatility is a Healthy Part of Equity Investing – FEDweek

By: Lyn Alden

It’s been a volatile few weeks for the TSP. The C Fund, for example, dropped about 10% from its January 26th high to its February 8th low, and then climbed about 6% back up so far. The S and I Funds have had similar performance.

Many investors worry when TSP equity funds become volatile. It’s an intense experience to see years of accumulated savings go up or down by huge sums in a short period of time.

But volatility is an inherent aspect of investing in equities and is what allows them to give investors such high returns over time. Stock valuations based on price-to-earnings, price-to-book, price-to-sales, dividend yield, and other metrics are still very high, and 10% market corrections are common and healthy occurrences to let off some steam.

The full year of 2017 was arguably the least volatile period in U.S. stock history, but the beginning of 2018 finally experienced a volatile correction. Here is the Chicago Board Options Exchange Volatility Index over the past five years:

Source: CBOE, displayed by the Federal Reserve Bank of St. Louis

We haven’t seen this high level of volatility since energy prices crashed a few years ago.

This length of unusually low volatility lured some investors into complacency, so that a sudden 10% drop in equity prices looks like a catastrophe. It even lured some professional Wall Street traders into using complex investments to bet against volatility itself, and those bets have ended disastrously.

For example, exchange traded funds that bet against volatility like the one in the chart below lost more than 90% of their value, practically overnight:

Source: SVXY, Google Finance

The unraveling of investments like this ironically contributed to further volatility in the markets. Many investors in these funds were using margin borrowing, and when their bets moved against them, they had to liquidate other assets to pay their margin calls, which meant further broad selling in healthy U.S. stocks.

Volatility and the Equity Risk Premium

It’s a good thing that stocks have volatility, because that volatility is what allows them to give investors solid long-term returns.

Stocks have what is known as an “equity risk premium” compared to U.S. treasuries and other low-risk investments. That’s the extra amount of annual returns investors expect to receive for dealing with extra volatility.

If stocks always had low volatility like they had throughout 2017, their equity risk premium over U.S. treasuries would be small. They would be extremely and perpetually highly-valued, resulting in low dividend yields and less-profitable corporate share repurchases.

But because stocks do have volatility, they historically give investors great long-term returns:

Source: 1997-2017 Returns, JP Morgan Guide to the Markets

Over any sufficiently long period of time, stocks have historically given better returns than bonds, and bonds have historically given better returns than cash in the bank.

However, investors should take their age and unique financial goals into account when determining how much of their wealth to invest in stocks. There have been periods where stocks underperformed for over a decade due to severe market crashes.

The younger you are, the more decades you have for high-volatility high-return investments to give you good returns over time. If you are closer to retirement, you have less time to recover from market crashes before retiring and can’t put up with quite as much volatility. Therefore, stocks are an important part of long-term investing but are usually reduced in a portfolio as an investor ages.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.

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