Volatility of the Stock Market

(3 of 5)

Volatility of the Stock Market

One way of reducing the risk of investing in individual stocks is by holding a larger number of stocks in a portfolio. However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly. You may experience large losses over short periods. Market dips, sometimes significant, are simply part of investing in stocks.

Things To Know

  • Despite the short-term volatility, stocks as a group have had the highest long-term returns of any investment type.
  • When the stock market has crashed, it has always rebounded.

History gives clues

For example, consider the Dow Jones Industrial Average, a basket of 30 of the most popular, and some of the best, companies in America. If during the last 100 years you had held an investment tracking the Dow, there would have been 10 different occasions when that investment would have lost 40% or more of its value.

The yearly returns in the stock market also fluctuate dramatically. The highest one-year rate of return of 67% occurred in 1933, while the lowest one-year rate of return of negative 53% occurred in 1931. It should be obvious by now that stocks are volatile, and there is a significant risk if you cannot ride out market losses in the short term. But don’t worry; there is a bright side to this story.

Over the long term, stocks are best

Despite all the short-term risks and volatility, stocks as a group have had the highest long-term returns of any investment type. This is an incredibly important fact! When the stock market has crashed, the market has always rebounded. And over the very long term, stocks have outperformed bonds on a total real return (after inflation) basis, on average.

If you had deplorable timing and invested $100 into the stock market during any of the seven major market peaks in the 20th century, that investment, over the next 10 years, would have been worth $125 after inflation, but it would have been worth only $107 had you invested in bonds, and $99 if you had purchased government Treasury bills. In other words, stocks have been the best-performing asset class over the long term, while government bonds, in these cases, merely kept up with inflation.

This is the whole reason to go through the effort of investing in stocks. Again, even if you had invested in stocks at the highest peak in the market, your total after-inflation returns after 10 years would have been higher for stocks than either bonds or cash. Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.

Time is on your side

Just as compound interest can dramatically grow your wealth over time, the longer you invest in stocks, the better off you will be. With time, your chances of making money increase, and the volatility of your returns decreases.

Some numbers, to illustrate

From 1928–2019, the average annual return for the S&P 500 stock index (including reinvested dividends) for a single year has ranged from negative 43% to positive 54%, while averaging about 10%. Five-year average annualized returns have ranged from about negative 12% to positive 24%.

These returns easily surpass those you can get from any of the other major types of investments. Again, as your holding period increases, the expected return variation decreases, and the likelihood for a positive return increases. This is why it is important to have a long-term investment horizon when getting started in stocks.