Volatility: In the Eye of the Beholder
Wall Street always likes to use fancy terms and phrases to complicate things. Liquidity, volatility and standard deviation just to name a few. Many of us know their technical definitions, but what do those terms really mean? Let’s start with volatility, one of the most overused phrases in my opinion. How would you define it? If you studied finance in school, I would expect the classical definition, “it’s a measure of dispersion around the mean.” While technically correct, what does it mean and why is it important?
Most of the time I hear the term volatility used when it’s unusually high. Like this headline from CNBC, “Brace for a lot more market volatility”. From that headline I would take it to mean, expect the market to go up and down more than usual. But when CNBC and other market pundits use the term volatility, it is typically in a negative connotation, to describe when markets are falling. That CNBC headline should have read, “Brace for a lot more market declines”. That would have been more simplistic. The unfortunate thing is that no one ever talks about volatility in a positive way. No one ever mentions that market volatility sent their 401k to a record high in 2019.
Let’s take another popular term, liquidity. What does that mean to a Wall Street type and non-Wall Street type? It’s an important concept since America excels at this one. Liquidity is generally thought of as the ability to get in and out of an investment quickly and cheaply. Think of it in terms of your personal investments. Stocks, ETF’s, and index funds are all quite liquid. Selling a hundred shares of Chipotle (currently my favorite COVID takeout place) is simple. It will take you less than a minute and the fees are generally quite minimal, especially if your accounts are at Schwab like most Apriem clients. Chipotle’s price is updated constantly, so the price you see is the price you get.
But how about your home? Aside from the need to clean and declutter your home (at least my home), a lot goes into selling a house. Most people would hire a real estate agent to help price and list the home and ultimately find a buyer. Once you find a buyer, you must agree to the price. Since there is no public price for my home, the transaction price is subject to many variables. Surely the buyer will want to pay less than what you want to get for it. Then after you agree to the price (if you can agree to the price), there is the traditional inspection process, escrow, and all that good stuff. Generally selling a home could take a few weeks to a few months. Clearly homes are much less liquid than your Chipotle shares. But is that good or bad?
Vanguard released an interesting paper the other week discussing the benefits of illiquid investments, specifically, private equity. The paper coincides with Vanguard’s recent decision to move into the private equity space after decades of avoiding them. (Jack Bogle must be rolling over in his grave). One of the many benefits of private equity is its lack of liquidity. Markets are emotional and thus the prices of all stocks like Chipotle can be emotional too. Sometimes TOO emotional. Since shares are constantly changing hands, the value of Chipotle changes too. Often too much during times of stress. In the past few months alone, Chipotle’s stock price has fallen in half and doubled in price. While surely, these are “volatile” times, how can a business like Chipotle be worth $25 billion one day, $12 billion a few weeks later, then almost $30 billion a few weeks after that.
But that’s where the rub is. Volatility is only bad if you act on it. It would be very unfortunate if you had to sell Chipotle at those depressed levels. That is where the liquidity issues come in. Vanguard claims the emotional nature of the liquid market can be a negative thing if you act on it. Investments like private equity and your home aren’t so liquid, so even if you wanted to sell at depressed levels, it’s lack of liquidity is a speed-bump to make you think twice. The value of your home doesn’t rise and fall every second. That lack of liquidity is actually a positive thing they claim, “strengths can be weaknesses and weaknesses can be strengths.” The lack of liquidity makes your home seem less volatile, even during crazy times. Schwab doesn’t give you a monthly report on your home value and if it was up or down that month. Not seeing your home change in value second by second makes people believe home values are less volatile and a better investment. Surely owning an investment that doesn’t rise and fall as much as Chipotle, is a good thing, right?
Take a look at the two charts below. Which one would you rather own? The one on the left looks pretty volatile. If this was the balance in your 401k, the big swings would be scary. The one on the right seems a lot less volatile. A little calmer. That’s the better investment, right? Well both charts are showing you the same investments. The one on the left is a chart of Chipotle using daily prices, while the one on the right is also Chipotle, but showing you monthly price data, specifically the end of the month. The starting line and finish line are the same, but that path you took is way different depending on how often you look at it.
Many of our clients look at their portfolios every day and some even have maintained elaborate spreadsheets of each accounts’ balances, every day. Of course, it’s very important to keep a close eye on your investments. But the more you stare at your portfolio or 401k balance, the more volatile it appears. Especially in the last few months, watching your investment balance rise and fall dramatically can make you batty. But if you simply look at your investments a little less, they will become less volatile. You can magically simulate some of the best traits of illiquid investment like private equity by just making a few small changes to your routine. And hopefully make you less inclined to make emotional decisions. Most times, the best thing to do is not make any investment decisions based on the crazy day to day moves of the market.
As always, please reach out to your wealth manager if you have any questions. Stay safe everyone!