Written by Preet Banerjee
Monday, September 30th, 2019
The price for higher potential long-term returns is higher short-term volatility. But when there's a stock market drop, it's harder to ignore the call to make changes to "my portfolio."
It would be great if we could just arbitrarily choose a high rate of return and see our money grow in a straight line over time, but we intuitively know it's not that easy. The tradeoff for trying to achieve a higher return is the acceptance of more risk. And in the context of a well-diversified portfolio, risk is volatility: the degree of fluctuations, both positive and negative.
We Get Distracted by Short-Term Noise
One of the problems of this tradeoff between higher potential returns and risk (or volatility) is that our attention can easily be drawn to short-term market volatility. It's unnerving at times and might get us second-guessing our long-term strategy.
One analogy that can help change our perspective from the short-term headlines and back to the long-term strategy is to think about a person playing with a yo-yo while walking up a mountain.
The short-term market volatility is like the yo-yo. Markets alternate up and down, day to day, over and over again. It's a bit mesmerizing at times. But by changing our focus to the big picture, the person's slowly making progress towards the top of the mountain. We see that in the context of long periods of time. While we had to put up with the constant "up and down-ness" of the markets, patience was rewarded.
Changing a Narrow Focus to a Wide-Angle Perspective
Looking at an actual long-term stock market chart, let's first look at the Canadian stock market with daily data points.
If you look here, it's possible to follow the S&P/TSX Composite Index over a day, five days, three months, six months and up to 10 years with just one click.
By looking at the chart, while over the course of a day or five days, there might be many fluctuations, over the 10-year period, it gradually moves upwards.
As you can see, if we can avoid a narrow focus (looking at short-term market movement) and instead focus on the big picture, we might be able to sleep better at night.
The Short Term is Unpredictable
The other thing you'll notice from all the charts is that while over the long term, the overall returns were positive, over the short term, there was no discernible pattern for predicting the next sequence of short-term returns. It's just too unpredictable. All the more reason to just tune out the short-term noise and focus on the long-term big picture strategy.
Remember: the price for higher potential long-term returns is higher short-term volatility. The more you can appreciate this simple idea, the more confident of an investor you can be.