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Volatility is back; time to keep your head down

The news just keeps coming like waves in a storm. One day, we hear that inflation is picking up. The next day, it’s down. No, it’s up again. Wait, we don’t really care because earnings are up.

In the past few weeks, volatility has returned to the stock market. Over the past two years, I have been surprised by the remarkable stability of stock prices. Despite a global and domestic economic situation that is as unbalanced as at any time in recent decades, stock investors have chosen to blithely stay the course.

Since January of this year, we have begun to see wider daily movements in stock prices. The market seems to be reacting more emphatically upon hearing either good or bad news. After several painful down days in a row, the market is up almost two percent as I sit here writing this.

What was deemed an awful market for stocks has turned into a wonderful market for stocks, all in the course of only 24 hours.

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The market is reacting most emphatically to hints of inflation. As I wrote here two weeks ago, an increase in the inflation rate is, on average, accompanied by poor performance in the stock market. If we look in more detail to times when stocks were already at the top end of a valuation range, stocks almost always decline when inflation picks up.

I am not the only one that can look up these numbers, and apparently other investors have an itchy finger on the sell-my-stocks button, too. Those investors have counterparts that have itchy fingers ready to hit the buy-me-some-stocks button on any hint of good earnings news. Bigger buy orders, bigger sell orders, more stocks bought and sold on margin than at any point in history, including during the tech bubble.

These are the ingredients for volatility, or large swings in prices. Higher volatility does not necessarily mean that prices will trend downward. I think they will trend downward for other reasons, but not simply due to volatility.

The problem with volatility is that it raises the risks of stocks significantly. The more that prices fluctuate wildly from day to day, the harder time we have in making decisions about what is a fair price to pay. Our odds of making mistakes goes up dramatically. Further, the risk that we suffer a loss by selling our stocks rises.

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All accounts must eventually liquidate. After all, we own stocks so that we can sell them some day and buy groceries or pay for our kids’ college. If stocks have suffered one of their volatile down weeks just as you have to sell to pay tuition, that volatility delivers some real pain upon you.

Despite the severe 2000-2002 drop in stock prices, an entire generation of stock investors does not appreciate the true risks of owning an unpredictable, ill-behaved investment. We really need to ask ourselves if mid-single digit annual returns are worth double- and triple-digit annual variations in our account values. I happen to think it is not worth it.

The price movements of recent weeks are serving to once again remind me - and you - that stocks are risky. They are not as safe as bonds, as the authors of “Dow 36,000" would have you believe.

I continue to be surprised when investors who are willing to take risk put all their money in the stock market. They play a song in their heads called, “If you take risk, you get paid for it.”

I am sorry to say it, but no you don’t. If you take risk, you might get paid for it, and you might not. Some investment decisions almost guarantee that you will lose money, yet people make them anyway because they involve risk.

If you have an appetite for risk, you need to take your risk wisely. Do so in asset classes that are not at historic high levels of valuation. Do so in asset classes where you can control your risks, or at least make a detailed evaluation of the odds of success. Diversify relentlessly. Owning a dozen different stock mutual funds is not diversification. It is still just one investment: stocks.

Above all, be willing to be patient and sit on the sidelines. Earning a few percent in cash while the stock market bounces all over creation never hurt anybody. The same volatility that makes stocks so risky will eventually lead to an oversold situation, where the return potential of stocks once again rises to the level where the risk is worth it.

Until then, keep your head down.

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Rick Ashburn manages investments for private clients. Write to him at rick@richardashburn.com or 7777 Fay Ave., Suite 230, La Jolla, 92037.