Don't Fear It: Volatility is Our Best Friend

By Nick Fisher, Portfolio Manager


I have previously discussed the biggest risk in today’s markets is that investors will be unable to achieve their goals. In terms of retirement planning, either investors will have to work longer or save more, and current retirees will risk outliving their funds. High valuations, and thereby low expected returns, are the culprits. 

We have been positioning our clients to weather this environment and fortunately, the significant increase in volatility recently seen is here to help. As a matter of fact, we are dependent on volatility to achieve our goals. To fully appreciate this, we must dissect the source of investment returns.

To begin, here is our formula for better understanding investment returns: 

Earnings Growth + Dividends + Valuation Change = Returns

What we haven’t discussed in detail is the importance of dividends and the nuance associated with returns. Jeremy Siegel (Wharton Finance Professor) has said dividends, and more importantly their reinvestment, are an integral reason why investors can experience sharply higher returns over long time horizons. This is especially true when you have volatility along the way. The reason is simple: as you receive quarterly dividends, you are buying more stock each quarter and if you are buying that stock at lower prices due to volatility, that is a great thing. As time goes on you own more and more shares and, while the impact of this in 3-5 year periods is small, the impact of dividend reinvestment over 10-15 years is substantial.

Consider that the 10 year increase in share price of the S&P 500 from 2004 to 2014 was 70%. However, after you factor in dividend reinvestment, it was 108%. In this low return world, that difference could mean not outliving your money. Of course, this requires an incredible discipline to buy and hold an investment through difficult times, such as those experienced during 2008/2009. 

The important thing to remember is that returns substantially benefited from reinvesting at lower prices afforded by volatility (as the mantra goes, buy low and sell high). So while it sounds counter intuitive at first, it makes perfect sense that a value investor should come to love and welcome the volatility of these time periods. For the average investor, they may come to depend on it.

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