If you have ever watched your investment account drop and felt fear or panic, you are not alone. Seeing your hard-earned money decrease in value can be concerning, especially when the decline continues for days, weeks, or even months. But while these periods can feel alarming, volatility is not a flaw in the stock market; it is the price of admission.

For long-term investors, understanding that volatility is an unfortunate necessity of investing is a key point to help bring peace of mind to your financial plan. The stock market does not move upward in a straight line. Instead, it experiences frequent daily declines, occasional significant downturns, and, from time to time, full-fledged bear markets. The key is learning how to distinguish between normal market fluctuations and a genuine change in your financial plan. More importantly, investors need to understand why accepting some level of volatility is necessary (and even beneficial in some cases) to capture the long-term growth that stocks can provide.

What is Volatility?

Volatility in the stock market refers to the “ups and downs” an investor sees in their portfolio. These price fluctuations can be a real concern for most investors, especially over prolonged periods of time. Although it can be uncomfortable to watch your portfolio decline, this is a perfectly normal part of investing in the stock market, and it can even benefit long-term investors.

Checking your portfolio every day isn’t advised because of the fear and anxiety it can produce, but some investors (myself included) can’t help it. If you fall into this category, 47% of the days you check your portfolio, you will see red. That’s right, nearly half of the year ends in a decline in the stock market! Seeing so much red, sometimes for weeks on end, can create a real panic and fear in and investor, and can lead to rash decisions of panic selling, chasing short term trends rather than keeping your eye on the long-term prize, and many other behavioral finance traps.

Why You Should Weather the Storm

For those of you who are Dave Ramsey followers, I’m sure you already heard this: “The only ones who get hurt are the ones who jump off the roller coaster.” Sometimes, that is much easier said than done. However, it is important to remember that these declines are perfectly normal throughout any given year. Despite only being positive for roughly 53% of the trading days in a year, the market’s annual return still is positive 80% of the time. Even though you will see days ending in red 47% of the time, you can still take solace in the fact that 8 out of 10 years, you will be seeing a positive annual return.

Another way to think about the stock market intra-year declines is shown in the graph below, illustrating the largest intra-year draw down with a light green diamond, and the return for the entire year with the green bar:

Despite every year having a decline throughout the year, most years still ended positively. As you see red through your portfolio, it’s important to remember that this happens, usually for substantial periods, every single year, and yet it still works out 80% of the time to result in a positive year.

But what if we’re looking at the other 20%, and staring down a loss year?  These unfortunately do still occur; we still need to deal with the occasional bear market. Below is a chart taking a look at every bear market for the S&P 500 since 1950 (see John-Mark Young’s article Bear Markets: Normal But Not Fun for more details)

On average, a bear market declines for 338 days, with an average decline of 30.2%. On average, these market declines take 603 days to recover. That is 1.7 years to return back to the starting point! This can be a serious concern for investors, especially those utilizing this money to live on in retirement, or saving in the stock market for a short-term goal. It is important to note that this only applies to the S&P 500, and following Dave Ramsey's Four Categories should offer further diversification to reduce these drawdowns, although it is not a guarantee. This is why analyzing your investments based on the time horizon of your goals is essential, to reduce exposure to the sequence of return risk.

With All This Volatility, Why Own Stocks at All?

With 47% of all days being negative, it is perfectly understandable to be apprehensive about the stock market. Pair that with horror stories of extended market declines, with the 2008 housing crisis living prevalently in most investors’ minds today, it can make sense that some investors want to avoid it all together. However, there is countless evidence in support of owning stocks for the long term. Before we dive into these numbers, there are a few important details to keep in mind:

• Your time horizon should shape how much stock you own. As discussed above, in bear markets, there is substantial time to recover from the decline. When funds are needed in a short period of time, this can put a substantial strain on financial goals. The question I get most is “How money should be invested (if at all)?”, and my answer is always the same: “Well, what is your goal?”. It is impossible to give sound investment advice without understanding the intent of that money. A good rule of thumb is that shorter time horizons require safer investments.

• Risk tolerance and risk capacity are different, both should be carefully considered. Despite the insurmountable evidence supporting stock investing for long term goals, there is a real fear and anxiety that comes with that for some investors. This is where the idea of risk tolerance and risk capacity come in to play:

  • Risk Tolerance – how much risk an investor feels comfortable taking on

  • Risk Capacity – how much risk a plan allows for

These two ideas are key to deciding what portion of a portfolio belongs in stocks. A client’s risk capacity might support an all-stock portfolio. For example, they might be in their late 20s with nearly 40 years until retirement. That doesn’t necessarily mean they should invest that way if their risk tolerance means they’d lie awake every night worrying about their financial future. The opposite is also true. A retiree may feel comfortable taking substantial risk (high risk tolerance), but if they are living on a large share of their savings, a major market drop could leave their plan in ruins (low risk capacity). It’s important to understand these differences and how they affect your goals when investing.

For the average investor, most investing is done with retirement savings as the goal, which typically has a fairly long time horizon. This is considered the “accumulation phase”, and is an essential time for stock investing. Stocks often deliver superior returns over other asset classes during extended time horizons. From 1995-2024, a 100% stock portfolio averaged 10.92% per year, while a 100% bond portfolio averaged 4.56% annually. Although bonds are much less volatile, investing in stocks offers a significant outperformance year over year. This outperformance gives the substantial benefit of preserving purchasing power by outpacing inflation.

Since 1802, the average real return (the return after inflation was taken out, or how much your portfolio grew while accounting for relative price increases of goods and services) for stocks was roughly 6.6% annually. This means that not only will you be able to preserve the value of your investments by increasing your assets with inflation, but your money will continue to grow over an extended period of time on top of the inflated price of goods and services. Using the Rule of 72, this means that after inflation, your funds will double roughly every 11 or so years. Again, that is on top of the growth that can be solely attributed to keep pace with inflation.

Although there are assets that may be good inflation hedges, or can outpace and grow in excess of inflation within a given small sample size, there is no investment that can create these returns in excess of inflation over an extended time horizon, let alone well over 200 years. Although in shorter time horizons this may not be the case, longer time horizons require stocks to truly have your money grow for you even after the price of goods rises.

The Bright Side of Volatility

Although the volatility associated with the stock market causes substantial fear for some investors, it is important to understand that it can actually be used for the benefit of the investor if done properly. Several proven strategies exist to help investors take advantage of volatility in the market and even improve their returns in some instances:

• Buying low and selling high is the ultimate goal of every investor to maximize their profits. Volatility in the market allows for this, as dips can be an opportune time for investing. Although it is nearly impossible to time the market, volatility at least allows for possible investments in a lower market (although not necessarily the lowest). However, it is important to remember that time in the market almost always beats timing the market.

• Dollar-Cost Averaging is investing the same dollar amount on a set frequency (monthly for example). As the stock market fluctuates, the investment will be made at different price levels rather than one set price, and typically results in a lower average price as a result. This forces some “buying low” in an account throughout the year.

• Automated Rebalancing can be an incredibly effective strategy, especially within Dave Ramsey’s Four Categories. As the different investments fluctuate and grow at different rates, rebalancing takes the excess growth of one investment and distributes it to the others. This takes advantage of price fluctuations and “automates” every investor’s goal of buying low and selling high.

• Tax Loss Harvesting is the most nuanced of the options, as there are several different considerations to be made in order to utilize this strategy effectively. At a base level, tax loss harvesting involves selling investments in a brokerage account at a loss, and utilizing that loss to offset gains in the current or future years. For a more in-depth look at tax loss harvesting, please view the article Bear Market Strategy: Tax Loss Harvesting.

Conclusion

As uncomfortable as volatility may be, it is the price of admission for stock market investing and the long-term returns associated with it. It is important to keep in mind that successful long-term investing comes with a simple trade off: higher long-term returns require periods of market uncertainty and return. The idea of more risk equaling more return is prevalent in the stock market. However, extended time horizons substantially reduce the risk associated with investing in the stock market, and can even provide added benefits in some cases.