Personal Finance Essentials
Understanding Risk and Volatility
Successful Investors Don’t Avoid Volatility
They Understand It, Plan For It and Stay Invested
Volatility Is Not the Enemy
Many investors fear stock market volatility. But volatility is not a reason to avoid stocks – it is simply a characteristic of stocks. Prices go up and prices go down, often dramatically. Since 1900, the stock market has experienced more than 300 declines of 5% or more, lasting an average of 40 days. These declines occur roughly three times every year on average, and about a third of them worsen before they recover.
In the last 100 years, there have been 29 declines of 20% or more. The market recovered from every single one of them. Short-term unpredictability should not dissuade you from owning stocks. The market’s long-term direction is upward. Short-term declines are the price of admission.
Standard Deviation and Setting Realistic Expectations
Beyond the simple question of “up or down,” there is a more precise way to understand risk: standard deviation. Standard deviation measures how much an investment’s returns tend to deviate from its average. A fund with an average return of 8% per year and a standard deviation of 6 can expect returns to range from 2% to 14% in any given year, two-thirds of the time.
This matters because it helps you set realistic expectations. Investors who focus only on average returns are often shocked by a poor year they had every statistical reason to anticipate. Those who understand standard deviation know that a bad year doesn’t necessarily mean anything has gone wrong. The goal is not to avoid volatility – it is to understand it and to build a portfolio whose volatility matches your personal ability to stay the course.