Check out the chart below showing the performance of the Dow year-to-date:
Source: Google Finance
The ups and downs are enough to make any investor nauseous. What’s often lost in these charts is the real cost of volatility – a cost often overlooked by many investors. And that cost is the cost of recovery from losses.
In a volatile market, investors tend to shrug off losses. Most investors expect the market to rebound quickly. For example, if the market drops 10% in a session, a common reaction is waiting out the drop and hoping the market will bounce back. The market only has to rebound 10% to get back to normal, right?
Wrong. That’s because losses have a more profound impact than gains. After a loss, it takes a greater gain to get back to the original value.
It’s simple math.
The Real Cost of Volatility.
Here’s the simple math:
If you start with $100,000 and your value drops 20%, it will take a 25% gain to get back to your original value of $100,000. That’s because when you lose 20%, you’ll have less to work with. You’ve gotta climb out of the hole from $80,000. It will take a 25% gain to make up that $20,000 loss. The hole is even deeper if you need to withdraw cash to cover expenses. Even if you withdrew just 5% a year over five years, the 25% gain needed to get back to normal then becomes 82%, as demonstrated in the chart on the previous page.
Why Be Concerned About Current Volatility.
Volatility is a reflection of investor sentiment and uncertainty, and the factors that affect investor sentiment and uncertainty are numerous. Economic factors, economic news, interest rate changes, fiscal policy, geopolitical turmoil, and social media are some of the prime suspects that influence investor sentiment and uncertainty.
The recent stock market volatility should surprise nobody for anyone keeping score at home. The primary factors that fuel investor uncertainty have recently reared their heads, including inflation, rising interest rates, war, high fuel prices, political conflict, and recession warnings.
Better To Avoid The Loss Than To Recover From One.
Suppose the recession warnings that are coming from the four corners eventually materialize. In that case, the losses from the stock market could mean a long road to recovery for those investors who stay in. The post housing bubble burst in 2008; The S&P 500 dropped nearly 50%. It took almost seven years to get back to pre-crash levels.
In a volatile market, smart investors double down on assets uncorrelated to the broader markets. By leveraging private alternatives, they insulate their portfolios from volatility – avoiding the losses that plague the broader markets and the long road to recovery many mainstream investors will face in the aftermath of a downturn.
Why not just avoid the loss rather than have to recover from one?