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  • Dr. Andy Lawson Ph.D.

Why volatility is good for long-term investors

Updated: Dec 15, 2022

1. Stocks’ returns are higher and more volatile than those of bonds


Figure 1 charts the annual returns of the US stock market for the prior 95 years. The average annual return is 12.2%. Notice that annual returns vary widely from year to year and are negative in 23 of 95 years, or in 25% of years. During the same period, the US bond market has returned an average of 6% per year with less than half of the annual return variation of stock returns. Thus, stocks have high returns and high short-term volatility compared to bonds.


Figure 1 - U.S. stock market returns 1927 to 2021—one-year holding period.


2. Stocks’ returns are high due to their high short-term volatility


Stocks' high returns are partially attributable to their high short-term return volatility. To see this, let’s use a counterfactual argument (an argument in which we assume something we know to be false to be true).


Stock market timing does not work.[1] But imagine a world in which market timing did work. Investors would buy stocks in advance of market rises and sell them in advance of market declines. This would smooth out the market’s ups and downs and reduce stocks’ returns. So, if the volatility of stocks was lower, then the reward for holding stocks would also be lower. Therefore, investors should prefer a world in which stocks retain their short-term, unpredictable volatility.


3. How can investors take advantage of stocks’ short-term volatility?


Investors can earn stocks’ high returns while avoiding the large majority of stocks’ short-term return variability by having a holding period that is appropriate for holding stocks. Let's see what happens when we increase the holding period from one year to five years. Figure 2 shows the average annual returns for rolling five-year holding periods.


Figure 2 - U.S. stock market returns 1931 to 2021—five-year holding period.


If we compare Figure 2 to Figure 1, we notice a dramatic decline in volatility. Average annual returns of five-year holding periods vary much less than the returns of one-year holding periods and are negative in only 8% of five-year periods.


In general, as the holding period lengthens, the volatility of the average annual holding period return decreases dramatically.[2] Intuitively, the longer the holding period, the greater the opportunity for good years to offset bad years resulting in the average annual return for the holding period to converge to the long-term average return.


4. Conclusion


Investors with longer holding periods should prefer a world in which stocks experience high, unpredictable short-term volatility since this volatility is in large part responsible for stocks’ high returns.

 

Data source: Kenneth R. French Data Library, Tuck School of Business, Dartmouth College and SBBI 2022 Yearbook.

My thanks to David Welch, Citibank and Alexandra Neff, Bank of Texas

[1] The failure of reliable stock market timing is discussed in an upcoming article. Also, see Fama (1970), Sharpe (1975), Jeffrey (1984), Fama (1991), Graham & Harvey (1996), Chua & Woodward (1986), Jiang (2003). [2] More precisely, in a stable inflation, interest rate and equity risk premium environment, as the time horizon lengthens, the annual average return from stocks does not change, but the variability of holding period average annual returns declines significantly.

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