Stocks are volatile. And a big reason they’ll remain volatile is because of where a stock’s value comes from.
The value of a stock today is the sum of all the cash flows (dividends) a business (stock) will deliver to its shareholders in perpetuity, discounted to the present at an appropriate discount rate.
Not to get fooled by the apparently trivial setup above, small changes in i and r can have profound implications on the value of a business (stock).
Every business eventually returns profits back to its shareholders in the form of dividends, D.
Not all businesses will or can. Some won’t be able to get to that point but hold a decent number of them spread across industries and the dividend stream continuing in perpetuity is a near certainty.
r defines the growth rate of those dividends. That is tied to business profits and profits tend to grow long-term. But they don’t grow in a straight line and hence the associated volatility.
The discount rate, i quantifies risk. The greater a risk to profits, the higher a rate of return you’ll demand. You want to get paid for the extra risk you are shouldering with a riskier investment. Your expected rate of return hence rises for that investment.
And expected rate of return is the discount rate. So, when the discount rate rises and with it being in the denominator, the value of a stock falls. And when the discount rate falls, the value of a stock rises.
That is why changes in interest rates cause stock prices to change. The discount rate is not derived in a vacuum. It relies on prevailing interest rates in an economy and if the prevailing interest rates are rising, discount rates rise as well. If you can safely earn say eight percent on a 10-year Treasury bond, why would you want to buy stocks and expose your money to risk? So, when interest rates in an economy are higher, discount rates are higher and stock prices hence, are lower.
So, with r and i constantly changing, the derived value of a stock changes as well. And hence the inherent volatility with stocks. You cannot avoid that.
That makes the growth side of your portfolio.
Now with bonds and using the same equation above, cash flows from bonds are the interest payments you’ll receive. Let’s continue calling them D.
But D for bonds is fixed. They don’t grow once a bond is purchased (r = 0).
The discount rate i for a bond is the interest rate set when you bought that bond. So, unless you decide to sell that bond before it matures, the discount rate doesn’t change and so doesn’t a bond’s value.
Bonds preserve capital. They hence make the capital preservation part of your portfolio.
If you want complete preservation of capital, growth cannot come. If you want growth, you must accept volatility. You must accept it because that is the only way to outpace inflation in the long run.
So then why do we come across these investments that claim to preserve capital but also offer growth? Here’s one, LJM Preservation and Growth Fund that did such a fantastic job of preserving capital that it went belly up overnight. Jeff Malec in a piece at Seeking Alpha, LJM – The Autopsy does a great postmortem analysis of what happened there and provides this excerpt as the conclusion.
In the span of 48 hours in and around that spike, LJMIX had lost 82% of its more than $700 million in investor assets, failing to strike an NAV for several days as the manager, clearing firms, the exchange, and regulators tried to sift through the trades. It was the investment manager equivalent of a suicide, overdosing on the tempting drug of an investing free lunch.
Ah an investing free lunch. Free lunches don’t exist, especially in the world of money. Actually, there is one and that is to swallow the bitter pill of volatility while staying the course.
But who buys this sweet pitch of capital preservation AND growth? Unfortunately, many of us do because it sounds so, so good. Get all the upside with no downside. What’s not to like there?
Actually plenty.
Capital preservation and growth doesn’t exist. It is an oxymoron. Capital preservation means elimination of downside. Eliminating downside means eliminating volatility but then you don’t get the upside. We just did that math.
So, if you want growth, you must accept volatility – both on the upside and on the downside.
Risk and return are inextricably intertwined. In almost every country where economists have studied securities returns, stocks have had higher returns than bonds. Further, if you want those high stock returns, you are going to have to pay for them by bearing risk; this is a polite way of saying that in the course of earning those higher returns, your portfolio is going to lose a truckload of money from time to time. Conversely, if you desire perfect safety, then resign yourself to low returns. It really cannot be any other way.
William Bernstein, The Investor’s Manifesto
It is unfortunate that we tend to focus so much on what’s happening to our money from day to day that we forget that long-term returns are the only thing that matters.
Investor wisdom, however, begins with the realization that long-term returns are the only ones that matter. Investors who can earn an 8 percent annualized return will multiply their wealth tenfold over the course of 30 years, and if they have half a brain, they will care little that many days, or even years, along the way their portfolios will suffer significant losses. If they are, in fact, anguished by the bad days and years, they can at least comfort themselves that the rewards of equity ownership are paid for in the universal currencies of financial risk: stomach acid and sleepless nights.
William Bernstein, The Investor’s Manifesto
One way I lower the volatility of my portfolio is by not peeking at it as often. That is not as easy in this era of instant everything. But that app on your phone alerting you on every move the markets make is the worst thing that will ever happen to you and your money.
But not everybody can take the heat so incorporate investments into your plan that reflects that reality. That’s where bonds come into play. The ‘right’ ones in the ‘right’ proportion can act as ideal ballasts against stock market volatility. You might not earn on the bond portion as much, but they’ll help you sleep easy.
Because the goal in the end is not to die rich but to avoid living out retirement in poverty. And if portfolio volatility beyond what your stomach can handle gets you off your plan, that will not be good.
My own money is almost all in stocks with a trickle of bonds at the margins. The reason I mostly invest in stocks is because I invest in our civilization continuing to thrive. There is no Plan B.
Every human being on this planet should be able to live a full, happy life. There is a lot of work left to be done in that department. There is a lot of growth to be had. And ownership of businesses (stocks) is an ideal and believe it or not, riskless way to own a piece of that eventual growth.
Thank you for your time.
Cover image credit – Mike, Pexels