TCS Daily

Three Cheers for Volatility!

By James K. Glassman - April 10, 2000 12:00 AM

When a market index rises and falls by hundreds of points in a single day, is that cause for concern? Should you worry about wild price swings in the stocks you own? Well, Warren Buffett, one of the most successful investors of all time, likes to say that volatility is the investor's best friend. What is he talking about?

Hard as it may be to believe, volatility is good for you. It means that the stock market is constantly offering you bargains. Buffett has found that "Mr. Market" tends to get carried away in both directions - investors overreact to both good news and bad. The result is rapid price changes, or volatility, otherwise known as short-term risk. But of course it's only risky if you plan to sell in the short term.

The overwhelming evidence says that if you hold at least eight stocks spread across different industries for the long term, you can expect an average return of 11% per year. So for those who follow my "buy-and-hold" approach, a bad day in the markets is really an opportunity to buy low and possibly beat that 11% expected return.

Think of it this way: if stocks all rose 1% each month, that would give you very nice, stable returns, but it would mean you could never find a bargain. Of course, it would also mean you wouldn't get nervous when the market plunges, but I have a cure for that, too. It's called the "Rip Van Winkle" school of investing, really just another way of saying "buy-and-hold." You would do very well by buying stocks and then ignoring them for 20 years. This method spares you a lot of anxiety, too.

If you're still concerned about volatility, you can take comfort in the fact that in truth, the markets have really not been very volatile. During the past 12 months the S+P 500, which represents 80-85% of the total market, has fluctuated between 1247 and 1527. That's like owning a stock that moves between $12 and $15 per share over the course of a year. How volatile is that? Not very.

Economists call it roughly "10% deviation from the mean." In other words, if the average price was 1387, then the high was slightly more than 10% above that level and the low was a little more than 10% below.

Of course, there has been a lot of volatility in individual stocks, tech stocks in particular. But you have to expect that. Since all stock prices are based on expected future earnings, it's very difficult to evaluate an Internet company with no earnings, or even losses. Perceptions change very quickly and prices follow them.

Recent volatility in NASDAQ has also resulted from a new element of risk for tech stocks: political interference. Such risk already existed for old economy companies, and their share prices had been discounted accordingly. The ultimate example, of course, is the tobacco industry. Philip Morris would be trading at four times its current level if it were a normal company with average political risks.

Political risk is new for technology companies, and it must now be considered by tech investors. As always, I urge you to buy and hold stocks in the companies you like. But if you're currently invested only in high-tech, you should consider diversifying your portfolio.

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