Why Market Volatility Is Not the One You Should Fear

Recently, we published a post on how even passive investors can use some strategies to take advantage of market volatility, such as by using extra cash that is available for long-term investing to buy stocks while they are “on sale.”  However, as our clients know–and, as we have discussed on Our2Cents–when we say “buy stocks,” we mean, “buy well-diversified, passively-managed stock mutual funds.”  We do not mean to imply that you should buy individual stocks–for three reasons. 

First, the likelihood of an individual investor (or even a professional investment manager!) picking stocks in a way that consistently matches, let alone beats, market returns is extremely slim. 

Second, we believe that it is detrimental for the average investor to be exposed to the increased volatility and risk of holding individual stocks (i.e. a portfolio of less than 50 stocks) as opposed to a mutual fund comprised of hundreds or even thousands of stocks.  (If you hold one of the individual stocks in the S&P 500, you will face twice as much volatility on average as compared with holding all of the stocks in the index.)

Third, market-wide volatility has different characteristics than individual stock volatility, making it a more palatable type of risk, as we discuss below.

Why Market Volatility Is Preferable to Individual Stock Volatility.  There are many examples of the market falling sharply or rising rapidly due to a major headline in the news.  In late June, for example, the UK Brexit vote caused a dip in stock markets around the world, with the S&P 500 experiencing a two-day decline of over 5%.  Similarly, economic releases such as unemployment and gross domestic product (GDP) statistics often spur immediate market declines if the data runs counter to investors’ expectations.  However, any event that causes just about every stock to behave the same way tends to be a short-lived phenomenon.  The market soon corrects for its overreaction, such as in the case of Brexit when, after its initial two-day decline, the S&P 500 surpassed pre-Brexit levels within a week and a half.  Even more significant market declines, such as market corrections (10% decline in stock prices) or bear markets (20% decline in stock prices), only last 10 months and 15 months, respectively, on average.  As evident from the fact that the S&P 500 is hovering near record high levels, the market has always recovered from downturns in stock prices.  In other words, all market declines to date have been temporary.  The same does not hold true, however, for volatility in the prices of individual stocks.

Specific breaking news about one company can have long term impacts on the value of that stock.  Demand for individual companies’ products or services can change as well as the capabilities of its staff or management, the legal or regulatory environment in which it operates, etc.  Individual companies do go out of business and leave their stockholders with nothing.  Recent examples of individual stocks that were once considered a dependable staple of investors’ portfolios and have dwindled to little or no value include Sears, Lehman Brothers, Dell Computer, Avon Products, Radio Shack, Fannie Mae, and more.  The impact of this on an investor holding the company’s stock in a mutual fund comprised of hundreds of stocks is obviously much less significant than on an investor holding its stock as one of only ten or twenty individual stocks in their portfolio.

As unnerving as market volatility can be, it is far preferable to the volatility of individual stocks.  Therefore, we advocate riding the wave of market volatility by investing in well-diversified, passively-managed mutual funds and foregoing the need to sweat the “breaking news” about any particular company or stock.