Volatility Returns With A Vengeance

After 15 straight months of record-breaking calm in the markets, we are finally seeing the return of volatility. To be clear, volatility is the norm for the stock market, not the exception. On average, the US stock market declines at least 10% roughly once a year -- and it lasts on average less than 100 days. A 10% drop is called a correction, and they are a healthy (if unpleasant) part of investing in the stock market.

There are plenty of reasons that corrections aren't as scary as you think. Here are a few ways to think about stock market sell-offs and volatility.

Let's imagine a world where the stock market only goes up…

If stocks never went down -- if there was no chance of loss, there would be no chance of gains either! How much would you pay for the future cash flow of a company's stock if it could never fall? And for that matter, you'd be crazy to ever sell it unless you needed the money for something else. The price you would pay for something like that is theoretically unlimited and you would hold it forever if possible.

Stocks would sell at thousands of times price multiples instead of the historical averages of 10-20 times earnings. And it would all be based on nothing at all. Stocks would remain elevated but go nowhere to the upside. Some shareholders might sell, and others would take their place at the same sky-high prices. We would achieve an equilibrium in which no one ever lost money, but no one ever made any either. Investors would turn to other opportunities to generate returns.

Volatility is one reason long term stock returns outperform safer asset classes

There's a word for the additional risk we take on when we invest in stocks: it's called the "risk premium". If there was no risk and no volatility, there would be higher demand for stocks (as opposed to cash and bonds), which would drive the price of stocks up because that guaranteed future cash flow would get baked into prices.

Stocks can go up because they can also go down. And that's what keeps investors in check and keeps them from paying infinite amounts of money for shares of a company. Fear plays a critical role here. It must be in an investor's sites at all times for there to be any future upside to capture. Long term investors should celebrate the reminder of fear in the markets. The panic you see in the scary headlines? That's the equity risk premium making its presence known (again).

This recent reintroduction of volatility is good for the long term investor in part because it drives away risk-averse investors. If the risk-averse investors sell when there is a correction, that's a great opportunity for investors with a long term mindset. In fact, when others bail out as the stock market goes down, that creates buying opportunities, which will increase your returns over the long run.

In summary, never forget that investors earn their returns by facing these fears precisely because many others won't. It's a bumpy ride, but that's the price you pay for long term returns.

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Alyssa Lum, and all rights are reserved. Read the full Disclaimer.