Volatility: A Regular Investor's Best Friend

Wall Street loves fear and greed. Every time some bad news hits, a lot of benighted investors sell investments that were basically solid. Causing the price they can get for their investments to drop (higher supply, lower demand). Every time a piece of unexpected good news hits, you can expect stock price to take a jump, and people rush in and pay too much for the security. Emotions: buy for too much, sell for too little, and pay transaction costs both ways. It's a recipe for tanking investments.



One of the first thing every financial text tries to teach you is dollar cost averaging, but few people learn it and apply it where it counts. If the company has solid management and it's doing well and is well positioned, chances are that them missing earnings per share targets by 7 percent for the quarter is just unimportant. It might be if it's part of a trend, but past results, or trends, rarely get reported with current ones in the financial press. Actually, you're lucky if they tell you about special charge offs influencing the result, or special one-time gains in the case of good news. Accountants can hide a lot, and make it appear to be other than it is. For these reasons as well as the above, you could do worse than to make "buy on bad news, sell on good" your investing mantra.



People get all kinds of irrational in the short term, especially about money. This is behind most of the legendary stock run-ups of the last several decades, most of which quietly slid back down after hitting a peak. As long as the reasons you thought the company was originally a good investment apply, keep on doing what you were doing.



Now I'm going to run a table of a $100 per month under two different suppositions. The first is that there is a smooth 10% annualized increase in price. The second is a small random walk (real world, prices are more volatile than this). Watch what happens over three short years.

month 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36

smooth increase $10.00 $10.08 $10.17 $10.25 $10.34 $10.42 $10.51 $10.60 $10.68 $10.77 $10.86 $10.95 $11.04 $11.13 $11.23 $11.32 $11.41 $11.51 $11.60 $11.70 $11.80 $11.90 $11.99 $12.09 $12.19 $12.30 $12.40 $12.50 $12.60 $12.71 $12.81 $12.92 $13.03 $13.14 $13.25 $13.35

total smooth 10.000 19.918 29.754 39.509 49.184 58.779 68.295 77.733 87.093 96.376 105.583 114.713 123.769 132.750 141.658 150.491 159.253 167.942 176.559 185.106 193.582 201.989 210.326 218.595 226.795 234.928 242.995 250.994 258.928 266.797 274.601 282.340 290.016 297.629 305.179 312.667

value smooth $100.00 $200.83 $302.50 $405.01 $508.37 $612.59 $717.67 $823.63 $930.47 $1,038.19 $1,146.81 $1,256.32 $1,366.75 $1,478.10 $1,590.36 $1,703.56 $1,817.70 $1,932.79 $2,048.83 $2,165.84 $2,283.81 $2,402.77 $2,522.71 $2,643.65 $2,765.59 $2,888.55 $3,012.52 $3,137.53 $3,263.57 $3,390.66 $3,518.80 $3,648.00 $3,778.28 $3,909.64 $4,042.09 $4,175.64

volatile price $10.00 $10.20 $9.80 $9.60 $10.50 $10.80 $10.10 $11.00 $10.70 $10.90 $11.20 $10.80 $10.60 $11.00 $11.50 $11.80 $11.00 $10.90 $11.60 $11.60 $11.90 $11.99 $11.75 $12.00 $12.40 $12.60 $12.00 $11.80 $12.40 $12.80 $13.00 $13.25 $13.00 $12.90 $13.40 $13.35

total volatile 10.000 19.804 30.008 40.425 49.948 59.208 69.109 78.200 87.545 96.720 105.648 114.908 124.342 133.432 142.128 150.603 159.694 168.868 177.489 186.109 194.513 202.853 211.364 219.697 227.761 235.698 244.031 252.506 260.570 268.383 276.075 283.622 291.315 299.067 306.529 314.020

value 100.00 202.00 294.08 388.08 524.46 639.44 698.00 860.20 936.74 1,054.25 1,183.26 1,241.00 1,318.02 1,467.76 1,634.47 1,777.11 1,756.63 1,840.66 2,058.87 2,158.87 2,314.70 2,432.21 2,483.52 2,636.36 2,824.24 2,969.79 2,928.37 2,979.57 3,231.07 3,435.30 3,588.98 3,758.00 3,787.09 3,857.96 4,107.49 4,192.17

Notice that the ending price is the same in both cases, but that under the volatile scenario, you have acquired more shares, and have therefore made more profit, by $16.53. Why? Because you bought more shares when the price was lower, and fewer when it was higher. This "weights" your good months for low prices more heavily than your bad months with high prices. Keeping in mind that you invested $3600, your profit is $592.17 instead of $575.64, that's a difference of three percent in the amount returned.



Now real world security prices are somewhat more volatile than this, and if you maintain this discipline for decades instead of years, the difference will be larger - much larger. I've seen five percent of the entire net result, as opposed to a hypothetically smooth return that ends up with the same price at the end of the period. That's the difference between $20,484.50 after ten years, and $21,508.72, and all from the same $100 per month (that would be $12,000 if you'd tucked it into a mattress).



People do the silliest things, jumping in and out of investments for short term inconsequentials. Just because they do it, though, doesn't mean you have to copy their foolishness. Indeed, having the intestinal fortitude to keep investing in a strong solid security when they hit a rough patch is one of the best times to be investing, because you're buying at depressed prices, when all those folks who panicked bucause the CEO's daughter had triplets, or similar nonsense that has negligible impact on long term performance, are selling cheap. If the reasons you were buying no longer apply, get out, but so long as they do, temporary hits to the price are a good thing when you're buying.



Caveat Emptor.