In the world of investing, the term "risk" conjures up images of dramatic market dips and soaring volatility. However, long-term investors must reframe their understanding of what risk really means. Short-term market volatility is not synonymous with risk; rather, it's a natural characteristic of financial markets that, if approached correctly, does not threaten long-term investment goals.

Understanding Volatility Versus Risk

Volatility is the statistical measure of the dispersion of returns for a given security or market index. Simply, it tells us about the range of potential outcomes in the short term. While these fluctuations can be unsettling, they are not inherently risky unless they impact the investor's ability to meet their financial goals over the desired time frame. This is why we always advise clients to have 2 years’ worth of savings, or any funds required in the short term, set aside.

The real risk for long-term investors is not achieving their financial goals. This could be due to several factors such as inflation eroding purchasing power, the failure to adequately diversify, or permanent loss of capital due to investing in failing businesses or sectors.

Volatility as Opportunity

Instead of a threat, short-term volatility should be viewed as an opportunity. Market dips can present buying opportunities for quality stocks at lower prices. We recognize these moments as chances to purchase valuable assets at a discount, adhering to Warren Buffett’s adage of being "fearful when others are greedy, and greedy when others are fearful."

Long-Term Perspective on Volatility

Historically, markets have shown a positive trend over the long term despite short-term fluctuations. For example, as illustrated in the chart below, the S&P 500 has experienced numerous periods of significant volatility since its inception, yet it has consistently delivered positive returns over decades. The key to benefiting from this upward trajectory is staying invested over the long term, thereby allowing the power of compounding to work. By trying to time the market there is more risk for negative returns.

 

 

Source: Fidelity investment finder

Mitigating Short-Term Volatility

To effectively handle short-term volatility, investors should:

1. Diversify Investments: Spread investments across various asset classes to reduce the impact of a decline in any single market or sector.

2. Maintain Adequate Liquidity: Reserve sufficient liquidity for immediate needs to ensure sales can be completed during a time of market stability rather than a downswing.

3. Keep Emotions in Check: Emotional investing can lead to poor decision-making. Maintain a disciplined approach to investing, with a focus on long-term goals, helping to mitigate impulsive decision making based on short-term market movements.

 

Short-term volatility is an inherent part of investing in the stock market and should not be confused with risk. The true risk is failing to meet long-term financial objectives. By maintaining a well-diversified portfolio, preparing for liquidity needs, and adopting a long-term perspective, investors can use the natural volatility of the market to their advantage, engaging with it as a tool rather than fearing it as a threat. This mindset shift is crucial for anyone looking to build lasting wealth.