Volatility in the stock market is almost always associated with risk. As such, it is commonly associated with drawdowns in the minds of many investors. However, the preponderance of evidence shows that volatility is a two-way street and is more beneficial than harmful when investing in the stock market.
Let’s examine this premise. The 91-day Treasury bill is regarded as a risk-free asset because of its short time horizon and repayment guarantee by the US Government. At the end of the 91-day period investors are assured of getting back their full principle along with accrued interest.
Long term government bonds, typically 10-year maturities, fluctuate much more widely in price than T-bills. Coupons on long-term treasury bonds are almost always higher than yields attached to T-bills in recognition of their greater risk. Since 1926, the annualized return for long bonds has been 4.8% versus 3.3% for T-bills. Thus greater volatility is compensated for with higher returns.
History shows that stocks are more volatile than bonds. It also shows that stocks have provided higher returns than bonds. Bonds are a contract between the buyer and seller with a promise to be paid back at some specified date. Stocks have no such guarantee. Since 1926, stocks have provided an annualized 10.6% return versus just 4.8% for bonds. Once again, the more volatile asset has returned more.
Volatility is a two-way street. How did the Dow Jones Industrial Average rise from 1000 in 1982 to more than 44,000 by the end of 2024. In simple terms, volatility was greater on the upside than on the downside. Over time, downside price movements become less important while the upside movements become all-important.
Looking at the question of volatility in connection with stock market cycles leads to the same observation on volatility. Bull markets have averaged a cumulative gain of 156% on average since WWII.
On the other hand, bear markets have declined by a lesser 32% on average. Of course, no one likes to lose 32% of their money, but over time bear markets become irrelevant because they are temporary whereas the bull market is permanent. This is why it is essential to remain fully invested at all times.
Golden Eagle has built the oldest database on investment style history which dates back to 1958. These data support Capital Asset Pricing Theory “to a T” given that volatility and returns have moved in lockstep fashion (high volatility=high return/low volatility=low return). A summary of these findings is shown in the table below.
It can be seen that high volatility associated with the rapid sales growth style has provided the highest return among the three classes. Day-to-day, month-to-month, and even annual fluctuations in price are greatest for this leading type of fund. However, these fluctuations become less visible and less relevant over time as gains accrue.
Investors must be patient in seeking high returns. Adopting a time frame of at least 5 years or longer is necessary in pursuing high returns. Consider these two choices, an investment in a high volatility rapid growth fund or an investment in a low volatility value fund over the past five years.
The average high volatility rapid sales growth style provided an annualized return of 15.4% versus just 8.1% for the typical low volatility value style. Again, volatility was rewarded with a much higher return.
It is important to remember that upside price volatility always exceeds downside price volatility when applied to the general market or various investment styles. However, the tenets of volatility do not apply to individual stocks. Because of this, it is important to invest in stock price prediction software.
Investors seeking high returns must understand and accept volatility. In seeking high returns, investors need to focus on the long-term rewards of volatile investments and not on fleeting short-term drawdowns. Even though the road to high returns is a bumpy one, it is the best path to earning greater rewards over time.
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Robert Zuccaro, CFA is the Founder & CIO of Golden Eagle Strategies. Over the course of his 40 year investment management career, Robert has managed market leading institutional portfolios and four mutual funds. He is one of the most successful investment managers having been named a top 10 manager in numerous years by the Wall Street Journal and Lipper Fund Survey. He’s also been cited for outstanding performance by Financial World, Investor’s Business Daily, and Business Week.
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