If a tree falls in the forest and nobody hears it, does it make a sound? You might say, “Of course it does!” and you’d be right. But what if five trees fall at once? Fifty?
If you are an active investor holding a small number of stocks or bonds, it might matter a lot. Your tree might be the one crashing down. However, if you own an index fund of the whole market, now you’re standing outside the forest entirely. Trees can fall every day and you won’t even notice.
That’s the strategy behind successful portfolio investing. As John Bogle, the founder of Vanguard Group, recently said in an interview, it’s the noise of those falling trees that’s the real problem.
That’s because people see rising and falling prices — the normal, unceasing action of the stock market trying to price thousands of assets in real time — and they feel a need to react, to do something.
The fact is they should do nothing at all. Volatility is normal and should be utterly ignored. “Don’t pay a lot of attention to the volatility in the market place,” Bogle said. “All these noises and jumping up and down along the way are really just emotions that confuse you.”
The question is not “Will my investments go up or down?” because of course they will. The question one should ask is, “Will the fact that investments go up and own bother me enough to do something dumb?”
You should know the answer to this question about yourself. Part of what a good investment advisor does for his or her client is to listen, to really hear the hopes and dreams and expectations of that individual.
It’s not data, it’s emotions. People want certainty and security, but they understand that risk is part of the retirement investing equation.
The goal, then, is to find a balance that produces a steady, compounding return while minimizing the impact of a poorly timed emotional reaction.
None other than Warren Buffett addressed the issue of risk and volatility in a recent letter to his investors. The “incorrect lesson that is often preached is that where volatility is used as a proxy for risk, which is dead wrong: Volatility is far from synonymous with risk and leads the everyday investor astray,” Buffett said.
For most investors, “risk” and “volatility” seem to go hand-in-hand. Experienced retirement advisors, however, understand that these are not synonymous. Rather, they are two sides of a coin, related but never touching.
Risk is the negative side of the coin. It suggest the chance of loss. We don’t like risk but we understand that it is part of life. If risks were completely unacceptable, we couldn’t leave the house, cross a street or drive a car.
Naturally, we seek to reduce risk where possible (seatbelts and airbags) and we insure ourselves against financial losses some risks could impose. In a portfolio, diversification and rebalancing play these roles by broadening our holdings and enforcing best practices.
Volatility, the confusing noises Bogle points out, is in fact a good thing for our portfolio. If you are a serious long-term investor with many years to go before retirement, a decline in stock prices is a chance to buy more, more cheaply. Buy stocks when they fall in price and go on sale, as Buffett has long advocated.
If you are closer to retirement, your risk-adjusted portfolio is going to be less volatile by design. Risk reduction from your own emotions can be achieved.
The true risk lies is betting on specific investments in hopes of beating the overall market. That’s how you set yourself up for the “falling-tree trap” and, eventually, expose yourself to emotions that cannot help but put your retirement in real danger.