Money Management and the Economy

Wednesday, October 22, 2008

Confusing Volatility and Risk

You aren't smarter than the market. It really is that simple.

The recent stock market crash has reminded many people that there is risk associated with buying stock. But that is really the wrong lesson for people to learn at this point. What the crash has shown is that the stock market is volatile, it will go up and down. But how much risk that creates depends on your investment horizon. If you plan to hold on to your stock for another ten years, then the recent crash has few consequences. The price in the current uncertain market says very little about the price you will get ten years from now when you sell the stock.

In fact, the stock markets' hourly gyrations have very little import for most investors, regardless of their investment horizon. Volatility is relative. Monthly fluctuations have consequences for short term investors. The decline in market prices since July reminds us why we shouldn't own stock that we will need to sell in a couple months for our immediate living expenses. On the other hand, even the decline in prices over the past year has very little meaning if your investment horizon is 30 years out. But the ups and downs over the last decade do have consequences.

In fact, if you have been buying stock over the past 10-15 years, if you sell now the chances are pretty good that you will have lost money. And that is real "risk", not simply volatility. And that risk continues to exist. Its possible that the money you are "saving" by buying stock may not be there at all. The boom and bust of the dot com bubble followed by the boom and bust of the real estate bubble make it clear that projecting the likely real value of that stock portfolio ten years from now is uncertain at best. While the argument that the market will go up "in the long run" is probably still accurate, we should remember that adage "in the long run, we are all dead".

What is important is to recognize that the current market value of our stock portfolio is not the same as money in the bank. That current market value is an estimate of our stock's value. Its very accurate in telling you how much money you will get if you sell today. But it becomes less and less accurate the longer it will be before you sell. If you are planning to start selling stock in 30 years as you near retirement, then today's market price is pretty meaningless in determining how much money you will get for it. In fact, given market volatility, it is almost guaranteed that if you get a range of different prices if you sell over a period of time. And the recent market makes it clear those could be dramatically different prices.

So your financial management software adds your bank balances to yesterday's market value of your stock and gives you a very precise amount that you have "saved", right down to the penny. Then you plan for your retirement or other financial decisions based on that number. The recent market has reminded us is that precise number is really a very rough estimate. Just think of it this way, "I have this much saved - plus or minus 40%".

Its also important to understand that while money saved in the bank is not as volatile as the market. There is still risk associated with it. The risk that inflation will be higher than the interest paid on your savings and the money you have in retirement will buy less than it does today.

Volatility of the market creates greater risk the shorter your investment horizon. The risk of inflation is greater the longer your investment horizon. This is why as you get closer to actually needing money, it makes sense to sell stock and put the money in savings.

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