How much volatility should I tolerate?
We’re clearly in a weird environment right now: inflationary, though some of that may be transitory; economy booming in some ways, lagging in others; isolated supply shortages, somewhat widespread labor shortages. And all of that means a lot of uncertainty and volatility. How much is too much?
I sort of view weathering volatility as the price to pay for winning this game over the long term.
We’re definitely facing some real volatility and changes in the market. Inflation is a real problem right now, with inflation rising at its fastest rate in 40 years. Some of it is probably transitory. Some of it is definitely driven by policy.
But none of that is good enough to make me change my mind about my investment portfolio, absent actual changes to the business in which I’m investing. Ultimately, over the long-term, any form of short-term volatility is almost always irrelevant.
Unfortunately, whenever there’s a spike in volatility, there’s a pronounced tendency in a lot of investors to abandon their investments. That’s when a lot of people second-guess their choices. But if you really want to be successful long-term investor, then over the short-term you just have to accept the fact that there will be periods when the market does down.
Changes in price alone doesn’t tell us enough to know if we should buy or sell.
It might help to remember that price alone tells us nothing, or at least very little. In other words, a lot of people are guided by price changes, i.e., when prices go down, they sell. But price alone without any connection to intrinsic value is meaningless. When your window into what you own kind of begins and ends with price, that is a losing strategy because that's a flimsy way to invest.
So, let’s say that I bought a stock that I really like after it had declined 60% from a tie, meaning that the price is at a pretty good discount relative to intrinsic value instead of being equal to its intrinsic value. But then over the next month, it goes down to 70% from a tie. That doesn’t sound like a lot, but it represents a 25% unrealized loss. It’s still not a big deal to me as long as my fundamental assessment of the company hasn’t changed.
It’s your insights about the business that will drive how you do over a long period of time.
In other words, if your underlying assessment of the business is correct, you’ll do well over time, even if the business seems to flounder in the short-term. In fact, if you can accept – or at least make peace with – that volatility, instead of trying to avoid it, then then your ability to deal with the market and make money over time will be much better.
In fact, that’s the time when you really want to have the opposite kind of mentality and instead double down and almost do nothing. If you can avoid selling after declines and getting too excited when prices go up, you’ll be ahead of like 95% of the people in this game (again, predicated on the assumption that your insights about the business and its underlying value are correct).
I don’t generally look at short-term unrealized losses. Now, if I still have an unrealized loss three or four years in, that’s a different story. That’s an indication of a mistake in how I valued the business. But over a month or two? No, that doesn’t bother me whatsoever.
This isn’t to say I never make changes to my thinking or strategy in recognition of market conditions.
For example, recently I’ve been moving a bit more into cash and other things that I feel that are high quality but a little more stable. I think that's a very logical reaction to the recent spike in volatility. The volatility does create a different environment, making some options more attractive that weren’t previously.
But I haven't been making core changes to my investing framework or decisions. You have to be the same investor going in as you are going out.
I will say that we are ultimately heading back to a more normalized environment.
This is important context for understanding the current level of volatility. For what it’s worth, the fact that we’re going from a crisis era monetary and fiscal policy position to a more normalized environment actually suggests that our economy doing reasonably well.
Yes, there's very real pockets of inflation, and our supply chain isn't built to deal with an economy with the kind of volatility we’ve seen over the past two years. But we shouldn’t breathlessly overinterpret what these issues mean either.