Volatility: unnerving, painful, absolutely vital
Sure, up-and-down price swings in stocks, bonds, or any other investment can be vicious. The more extreme the fluctuations, the worse the pain.
Behind those obvious drawbacks, though, lie real and important benefits that accrue to both individuals and the economy as a whole. The world would be worse off, not better, if volatility could somehow be banished from market life.
Everybody who owned a simple stock mutual fund these past few years knows about volatility. Look at a chart of the Nasdaq Composite index between 1997 and 2002, when it careened from below 1,500 to 5,000 and back again.
Accounting systems have been developed in both general economics and in investment finance defining volatility as a cost, a drag on the market, if you will. That is only one side of the coin.
Volatility serves the economy at large by attracting risk-takers to the markets, people who shoulder a burden that would otherwise have to be borne by society as a whole. The cost of risk, in other words, is shifted to a corps of volunteers rather than a general population of draftees.
Hark back to a day about 25 years ago, when we were beginning to dream of creating a worldwide hookup of computers that would be called the Internet. If we assigned that task simply to a central planning agency financed by tax dollars, all of us collectively would have had to bankroll every enterprise that failed along the way, as well as the few that succeeded.
That kind of approach was rejected. Instead, we let speculators foot the bill for much of the effort as they bought shares of Internet stocks, bonds, and mutual funds. The fracas that ensued, though messy as all get-out, has produced an excellent result.
Market volatility stoked this speculation. Lots of investors undeniably suffered when the fever broke in 2000-2002. But the next time you take advantage of the awesome convenience and efficiency made universally available by the Internet, ask yourself how we could have gotten the same benefits any other way.
Volatility gives voice to the difference of opinions among buyers and sellers that makes markets work. Take volatility out of the marketplace, and a lot of the dynamic tension goes, too. When markets stop doing their job, impending risks go undetected that might have been spotted by traders trying to gain an edge.
If volatility helps us collectively, how can it do the same for us as individual investors? Modern financial dogma says trying to outwit the market is a fool's errand, a zero-sum game in which there must be as many losers as winners.
Here is one way volatility can help an ordinary investor who recognizes the difficulty of beating the market-timing odds.
We resolve simply to feed an equal amount of dollars -- let's say $10,000 -- on the same date each year into two funds, the Hare fund and the Tortoise fund. Over a three-year period, we buy Hare shares at $10, $5, and $15, and the less volatile Tortoise Fund at $10, $9, and $11. Subsequently, the net asset value of both funds rises to $20.
When we check our statements, we find we own 3,020.2 shares of Tortoise, worth $60,404, and 3,666.67 shares of Hare, worth $73,333.40. Put that in your fable collection, Aesop!
The simple strategy we were following is known far and wide as dollar-cost averaging -- automatically buying more shares at low prices than at high prices. With a small amount of volatility, dollar-cost averaging gave us a small benefit. With a lot of volatility, it gave us a big benefit.
When people complain about volatility, what they usually mean is short-term risk of loss. That is not quite the same thing. Volatility goes up as well as down.
And anyway, why should we be put off by short-term variability if we are investing for the long term -- as Investment Company Institute surveys say 96 percent of all mutual-fund investors are?
When long-term investing is our true and steadfast purpose, we might prefer more interim volatility, not less.
Chet Currier is a columnist for Bloomberg News.
