Volatility: A Regular Investor's Best Friend

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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.

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Welcome to this week's edition of the Carnival of Investing. I'm sticking with my usual method of hosting a carnival -- listing a summary of each piece with the author's reason for submitting the post to the carnival (for those Read More

Dan Melson says that volatility is a regular investor’s best friend, moving from the generic dollar cost averaging concept everyone knows about through a reasonable explanation. Don’t let the presence of numbers scare you away. Read More

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This page contains a single entry by Dan Melson published on July 10, 2006 10:01 AM.

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