A Financial Fluffernutter
I wonder if former State Senator Jarrett Barrios ever admitted he overreacted to his son’s request for a fluffernutter sandwich? While most parents would have just said no, Barrios proposed some “anti-fluff” legislation in 2006. The resulting public outcry was equally overblown. Callers to talk radio shows complained of a totalitarian regime dictating our food choices. Bostonians love fluff and we will be damned if some Haavaad do-gooder is going to take it from us.
Massachusetts politics have always been volatile but cooler heads finally prevailed. No legislation was passed and the delightfully ooey-gooey creation is now celebrating the 100 anniversary of its creation in Somerville.
There is more at risk than a yummy lunch when stock market volatility is concerned. When stock goes up and down it scares the dickens out of many investors. Volatility is one of the principle reasons why most investors sell at a loss, or sit on the sidelines, and fail to benefit from the natural appreciation of the market. Investors frequently confuse volatility with risk, but the concepts are very different.
So what is volatility and what is risk? Let’s view the concepts through the eyes of Betty, a fictional but sweet as whoopie pie lunch lady. Betty scrimped and saved and now she has $100,000 dollars to invest. She doesn’t need the money for 20 years and asked The Wicked Smart Investor how it should be invested.
First we spoke about volatility which is a statistical measure of the dispersion of returns for a given security or market index. In simpler terms, it’s the up and down movement of stock or indexes as the market reacts to the news of the day. The market is constantly evaluating a company’s earnings and growth potential and placing a dollar amount on these. History has shown us that the market frequently overreacts and dwells on negative news. There is no doubt this can be scary. In 1974 the S&P Index return plunged by 29.72% only to rebound in 1975 by 31.55%. Today’s investors have one advantage over their grandparents: we have so much more research that shows a well-diversified portfolio, over time, increases more than it decreases. I cautioned Betty that market volatility is a constant, it’s always there. Think of the stock market and volatility like the ingredients of a Fluffernutter; once the peanut butter is overlaid with the Fluff they ain’t never coming apart.
Next, we talked about risk. Let’s define risk as the chance you’ll lose money on an investment. Inflation aside, I had some surprising news for Betty. I told her that over the long term, risk drops precipitously. For example, if she needed the $100,000 in three years, the stock market is risky because of volatility. When the market dives, it can take years to recover and during many rebounds, more than three. At a 10 year time horizon the risk is significantly lower; at 20 years it’s almost zilch. Ethically, I cannot promise you well diversified investing is as sure as Fluff’s Never Fail Fudge but consider this: all it takes for Betty to double her money in 20 years is a modest average return of 3.53%. If she gets 1.5% she still walks away with approximately $135,000. It would take the market declining over 20 years for Betty to actually lose money. In the history of the stock market, this has never happened.
If volatility really bothers you there are ways to reduce its effect on your investments. Speak to your advisor to find the optimal portfolio for you. Then, assert your freedom and treat yourself to Betty’s Fluff infused Harvard Squares.
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