Imagine No Volatility (I Wonder If You Can)

Stocks are wonderful.

The average return is 6.5 percent real. That tops the return provided from just about anything else. Stocks are the ticket to financial freedom for middle-class workers.

Stocks are awful.

Talk to people who have lived through a long-running secular bear market and you may never again put a penny into stocks. Stock prices fell by 89 percent in the years following the great 1929 crash. And valuations had not gone nearly as high then as they did in the years leading to today’s economic crisis. It may take us years or even decades to recover from what reckless stock investing has done to our economy in recent years. 

Stocks are wonderful. Stocks are awful. Can both things be so?

They are both so. Because of one factor — the volatility of stock prices. It’s stock volatility that makes stock investing so scary and confusing. Do away with stock volatility, and stocks would become the best asset class ever imagined.

I think it’s possible. I think stock volatility is optional.

Have you ever thought about what causes stock volatility? It’s the humans. The humans get excited about stocks and bid prices up to insanely high levels. Then, when prices fall (as they must when they are driven so high as to be unsustainable), the humans panic and send prices down to equally insane low levels. If we could teach the humans to invest less emotionally, we could make stock volatility a thing of the past.

Is there anything we could do to make stock investing less emotional and thereby reduce volatility? I believe that there is a lot that we could do.

Most investing experts urge us follow a Buy-and-Hold strategy. That means staying at the same stock allocation at all price levels. I believe that that is a terrible idea. Stocks obviously do not perform as well starting from high prices as they do starting from low or moderate prices. So why go with the same stock allocation at all price levels? I think that we should buy stocks in the way that we buy everything else — we should stock up (go with a higher allocation) when prices are low and stock down (go with a lower allocation) when prices are high.

Warren Buffett recommends just this. He says that we should be greedy when others are fearful and fearful when others are greedy. The historical record shows that Buffett is right. I have checked the record to see how much of an edge is gained by investors who are willing to defy the Buy-and-Hold mantra and invest in a valuation-informed way. The benefits are amazing. The data shows that the typical middle-class investor could retire five years sooner just by making this one change in his asset allocation strategy.

So why don’t we all do it?

It goes against human nature.

It’s easy to buy stocks when they are overpriced. Stocks become overpriced because they are popular. When stocks become popular, stock investing feels safe. It’s not. It’s when stocks are popular (and thus overpriced) that they are most dangerous. But our emotions tell us just the opposite message of the message that would be told by logic if only if we would listen to it.

There’s another problem. Most of the people who we think of as investing “experts” are tied in some way to The Stock-Selling Industry. Their job is to persuade us to buy stocks regardlless of price. Guess who promotes Buy-and-Hold most avidly? Yup — it’s the people who make millions getting us to let our guard down about overpriced stocks.

Say that doctors gave dietary advice in the manner in which investing experts give asset allocation advice. They would note that most of us are emotionally inclined to want to eat six pieces of chocolate cake every day, and in an effort to get us to like them would assure us that eating six pieces of chocolate cake every day is the only way to go for the long-term eater. We would die many years sooner but we would calling our doctors Saint Jim and Saint Susan in the way that many today refer to John Bogle as “Saint Jack.”

Good investing advice isn’t investing advice that makes us feel good at the time, but investing advice that provides the best returns in the long term. That’s not Buy-and-Hold. It’s valuation-informed investing strategies that work best in the long term. We should be looking for investing advisors willing to tell us why we need to resist the urge to follow Buy-and-Hold strategies, not for the ones who tell us that it is fine to give in to our emotional urges knowing that it is we who pay the price for such short-term thinking.

Another lesson that we need to learn is that price changes don’t matter.

That’s the lesson that the historical data teaches. Price increases aren’t really a good thing. And price drops aren’t really a bad thing. Price changes don’t really matter.

What matters? The productivity of the U.S. economy. It is the productivity of the U.S. economy that finances that 6.5 percent average return. Volatility is the result of our emotional reactions to various news developments and our expectations about what those news developments are going to mean for stock prices.

If we come to accept that price changes don’t matter, we will stop bothering to try to figure out the effect of news developments on stock returns. We will stop selling in reaction to what we view as bad news and we will stop buying in reaction to what we view as good news. Volatility will be gone. We will just have to get used to seeing that 6.5 percent gain year in and year out.

How terrible.

I’m joking. A world without stock volatility would be a wonderful world indeed. It would be a world in which we enjoyed all the good of stock investing and none of the bad.

You may say that I’m a dreamer. But, if you open your mind to a new way of thinking about stock investing, I won’t be the only one.


  1. Evidence Based Investing says

    If stocks did lose their volatility but still remained at a price which allowed a 6.5% real return then the number of potential buyers at that price would greatly exceed the number of sellers. This would drive prices up and returns down, therefore goodbye 6.5% real return.

    Your fantasy scenario relies on investors turning down stocks returning 6.0% real with no volatility. Such a scenario has no basis in reality.

  2. Rob says

    I understand the point you are making and I am grateful to you for putting it forward, Evidence.

    I struggled with this aspect of the question for a long time. I ultimately came to a different conclusion. But I advise those listening in to give serious consideration to what you are saying. We need to have many smart people address themselves to this question before coming to any firm conclusions, in my view.

    I believe that you are right that demand would be too great for non-volatile stocks for the difference in returns between stocks and most other investment vehicles to remain what it is now is. My tentative belief is that a diminishment in volatility of stocks would not cause the return for stocks to drop but the return of other asset classes (certificates of deposit, etc.) to increase.

    The reason why I say this is that I believe the return on stock to be FIXED. The stock return is not set by market forces. it is set by the productivity of the U.S. economy. For so long as the productivity of the U.S. economy is sufficient to finance an average stock return of 6.5 real, that’s what the average return must be (although there are of course differences for those buying stocks at different price levels).

    In contrast, the return on CDs (and most other non-stock asset classes) is NOT fixed and IS set by market forces. So my take is that, if the difference in return between stock and CDs became unsustainable, it is the return on CDs that would change and the return on stocks that would not.

    Stocks would presumably continue to pay a higher return than CDs even in world in which stock volatility was greatly diminished. But I am suggesting that the difference would be greatly reduced. Perhaps the average return on CDs would be 5 percent real compared to a return on stocks of about 6 percent real.

    This is all to the good for the typical middle-class investor, to be sure.

    Again, thanks for asking an important question. It helps us all to flesh out our thinking on these matters a bit.


  3. Evidence Based Investing says

    The reason why I say this is that I believe the return on stock to be FIXED.

    That is incorrect. The return on stock depends on the price that you pay for the stock.

  4. Rob says

    I obviously agree that the return you obtain depends on the price you pay, Evidence.

    It is the AVERAGE return that is fixed. It is the average return that is set by the productivity of the U.S. economy.

    Those who purchased stocks at the prices that applied from January 1996 through September 2008 are obviously not going to obtain a 6.5 percent return. But that doesn’t mean that the AVERAGE return does not remain 6.5 percent. The returns in the late 1990s were far greater than 6.5. Those returns were being borrowed from future years. All that we are doing today is paying back the returns we borrowed in the late 1990s to bring the average return back to 6.5 percent.

    The average return does reflect the economic realities. But the price for stocks does not reflect the economic realities at times when Buy-and-Hold becomes popular. When emotional strategies become popular, the price tends to be too high or too low. When emotional strategies become popular, investors are obtaining either a higher return than they would obtain in a rational market or a lower return than they would obtain in a rational market.

    A Rational market would always provide a return of something in the neighborhood of 6.5 percent, the return justified by the economic realities. There is no need for volatility in a Rational market. This is why I say that volatility is optional.


  5. Evidence Based Investing says

    The long term real GDP growth of the US economy is just over 3%.

    That is the return set by the productivity of the US economy.

    The 6.5% real growth in stock market returns comes from coupling that with the dividend yield. Dividend yield is driven entirely by the price paid for a stock and if that price is higher then the yield, and hence total return, will be lower.

  6. Evidence Based Investing says

    Another way to look at it is the Gordon equation.

    The Gordon Equation states that the long-term expected real (inflation adjusted) return from the market should approximate the inflation-adjusted compound yearly growth rate in dividends plus the current dividend yield. Historically for the S&P500 the real growth rate in dividends has been about 1.3% per year (1871-1973) and the dividend yield has been about 5.0% per year for the same time frame. The sum of the two is a little less than the historical 6.5% compound yearly return from stocks for that time period. This is explained by a near-doubling of the PE ratio (i.e. speculative return) from 1871 to 1973 which added to stock returns.

    We can assume (I think) that the 1.3% real growth of dividends will remain true. This leaves the rest of the real return on stock dependent on the dividend yield. If the yield averages 5% then we will see 6.5% real.

    However in a low volatility world the price of stocks will rise and yield will fall.

    Therefore real returns will be lower.

  7. Rob says

    Thanks for your contributions, Evidence.

    I think you are wrong in your conclusions.

    The returns provided to stock investors have to come from somewhere. They come from economic productivity.

    One of your claims is that: “The long term real GDP growth of the US economy is just over 3%..” It’s not only growth of GDP that we need to be looking at. We need to be looking at current productivity PLUS growth in productivity.

    The combination of all the various factors is what determines the total return paid to U.S. shareholders. That total return has been 6.5 percent real for a long, long time (for as far back as we have records).

    There is no reason why that number needs to vary from year to year. Rational investors would always price stocks on the understanding that that is the most likely average long-term return. Volatility is the product of investor emotion. We could overcome investor emotion by permitting honest posting on important investment questions on the internet and thereby educating investors as to the realities that The Stock Selling Industry would prefer that we not learn about.

    Or at least so says Rob Bennett, some guy whose claim to “expertise” in this field is that he managed to figure out how to get stuff posted on the internet. All smart community members keep that caveat constantly in mind.


  8. Evidence Based Investing says

    That total return has been 6.5 percent real for a long, long time

    Because of two factors. The yield of the investment (ie how much investors have paid for an investment) and the growth in that yield.

    One is a fundamental fact of the economy (the growth rate) and the other depends entirely on the price paid.

  9. Rob says

    However in a low volatility world the price of stocks will rise and yield will fall.

    This is the core point of contention. All the rest is just verbiage.

    You state this as if you know for certain that it is so. I am questioning your confidence in this claim.

    The claim is rooted in a belief that investors behave rationally (as is the entire Buy-and-Hold Model). Yet we saw most investors choose stocks back in 2000 when the guaranteed 10-year return on TIPS was 4 percent real and the likely 10-year return on stocks was a negative 1 percent real.

    The entire Buy-and-Hold house of cards (including the key claim you are relying on here) falls to the ground once you accept that investors cannot possibly make rational decisions for so long as a Ban on Honest Posting remains in place and investors cannot learn about the flaws in the Buy-and-Hold marketing slogans.

    If we permitted honest posting, the market (us!) would price things properly. We would then be in a very different world. None of the verities that millions of people (not just you!) have come to believe in would apply any longer.

    Buy-and-Hold can only survive in a world in which challenges to it are forbidden. It is a closed system. It seems true to those who have never heard the case against it. But it tumbles to the ground when investors are able to hear the realities.

    You keep repeating the same old marketing slogans. But they do not impress me at this point. Remember, I am the person who put a post to the Motley Fool board on May 13, 2002, pointing out the errors made in the Old School retirement studies. Those studies have not been corrected for close to eight years now. Rational Investing in a world in which the Buy-and-Hold marketing slogans cannot be questioned? I don’t think so.


  10. Evidence Based Investing says

    I agree with you that paying the same price for non volatile stocks as you would pay for volatile stocks is irrational.

  11. Rob says

    I agree with you that paying the same price for non volatile stocks as you would pay for volatile stocks is irrational.

    Yes, that would be irrational.


  12. says


    Didn’t realize price increases aren’t a good thing for my investments. I realize volatility isn’t the greatest, and if you think volatility declines, why not just short volatility then?

    What are your benchmarks for a “valuation-informed way”?

    Would are your action points?


  13. Rob says

    “Didn’t realize price increases aren’t a good thing for my investments.”

    Lots of people don’t realize it, Sam. That’s why we are in the economic crisis we are in today.

    You are thinking that you are an owner of stocks. Owners always want prices for the things they are selling to be as high as possible. So you naturally see price increases as a good thing.

    But wait. You are not solely an owner of stocks. You are also a BUYER of stocks. You buy new stocks all the time, no? Buyers naturally want prices to be as LOW as possible. You are rooting against your own interests each time you root for a price increase!

    The long-term return of stock is fixed by the productivity of the U.S. economy. For 140 years now, it has always ended up being about 6.5 percent real. So it’ probably going to end up being something in that neighborhood again.

    So price increases for the stocks you already own don’t help you. You are ultimately going to get the same return on those shares regardless of whether we see the price increases today or later on. But price increases today do hurt you re the return you obtain on the shares purchased after the price increases. The more prices go up today, the more you pay for those shares and thus the lower will be the return you will see on those shares.

    Price increases hurt you, Sam. I understand that this is a counter-intuitive belief in today’ world. But the logic chain is strong.

    I recommend a shift from the Buy-and-Hold Model for understanding how stock investing works (which teaches that prices do not matter) to the Rational Investing Model (which teaches that prices matter a great deal). If all investing experts taught the realities as an everyday thing, this sort of insight would no longer be counter-intuitive to people. If we all understood the realities better, we would all invest more effectively and there would be far less volatility. Stocks would offer higher returns at greatly reduced risk. It’s a win/win/win/win/win.

    The only thing standing in the way today is the belief that some still have in Buy-and-Hold. That’s the barrier that we need to overcome to move forward. I think that the way to overcome it is for all of us in the Personal Finance Blogosphere to begin writing about these topics regularly. We need a National Debate on the realities of stock investing in the post-Buy-and-Hold Era.


  14. Rob says

    “if you think volatility declines, why not just short volatility then?”

    Shorting is not the answer to anything, Sam. Shorting is a short-term strategy. It is only the long term that is predictable. Shorting is dangerous and should be left to those who spend years studying it.

    “What are your benchmarks for a “valuation-informed way”?”

    Valuation-Informed Indexing is Buy-and-Hold Investing with one change, Sam. Buy-and-Hold says that you do not need to take the price at which stocks are selling into consideration when setting your stock allocation. Valuation-Informed Indexing says that price MUST be taken into consideration.

    This one change changes everything. All of the craziness and confusion of stock investing goes away when you become willing to invest rationally (it is obviously not rational to ignore the price of something you are paying good money for). Once you make the switch, it becomes possible for the first time to set your stock allocation properly. That makes it possible to invest for a far higher return at far less risk. That makes it possible to retire five years sooner.

    For the society at large, permitting people to learn the realities of stock investing means an end to insane bull markets and the insane bear markets that inevitably follow from them. It thus means a great reduction in the number of economic crises we suffer (we have never once since 1900 suffered an economic crisis in the United States that was not preceded by a time when stock prices went to double fair value).

    When people invest rationally, the market is able to allocate resource to the businesses the merit them. That translates into higher levels of economic growth. Allowing Rational Investing would be freeing up capitalism to work its magic in a way that it has never been permitted to work it before.

    If we all were able to retire years sooner, a lot of the stresses we are seeing today in our political system would dissipate. Much of what we are seeing is anger brought on by the economic crisis caused by the reckless promotion of Buy-and-Hold Investing for 30 years after the academic research showed that the chances of it ever working in the real world are precisely zero.

    I hope you will help, Sam. If you permit honest posting on these questions at your blog, there are others in the Personal Finance Blogosphere who will follow your lead. We can do amazing things together — for you, for me, for the entire Personal Finance Blogosphere, and for the entire economic and political systems of the United States. Please give it some thought.

    And do ask questions if you have any. I’ve studied this in great depth. I am not kidding around when I say that we are looking at a win/win/win/win/win with no possible downside. You don’t get too many of those in the course of a single lifetime.


  15. Evidence Based Investing says

    The long-term return of stock is fixed by the productivity of the U.S. economy. For 140 years now, it has always ended up being about 6.5 percent real. So it’ probably going to end up being something in that neighborhood again.

    The growth in dividends is tied roughly to the growth in the US economy. The dividend yield itself is entirely a function of the price paid for that yield.

    Bill Bernstein has a good article which explains where stock returns come from.

    The Returns Fairy. . . Explained

  16. says

    Why doesn’t price change not matter? If I buy a stock at $100, and it goes to $50, and I lose my job and need to liquidate my stocks to survive, doesn’t that matter?

  17. Rob says

    Why doesn’t price change not matter? If I buy a stock at $100, and it goes to $50, and I lose my job and need to liquidate my stocks to survive, doesn’t that matter?

    The price assigned to stocks by the market always matters for that day, Sam. I certainly do not say otherwise.

    What I am saying is that insanely high prices do not apply for the long term. In the long term, prices always return to the level justified by the economic realities. Bogle says that Reversion to the Mean is the “Iron Law” of investing.

    So when stock prices go to three times fair value (as they did in 2000), the long-term investor can safely ignore the two-thirds of the price that represents overvaluation and adjust the nominal price down to what it would be if the market were setting the price rationally. Doing that permits you to engage in effective financial planning.

    Imagine that you were thinking of taking early retirement in 2000 based on the nominal value of your portfolio. Since that value was three times real value, your early retirement probably has very little chance of surviving. What you want to do is to perform the adjustment needed to know the true value of your portfolio. Then you check to see whether, using the real numbers, you still are in a position to hand in a resignation and begin an early retirement.

    The question of whether crazy price changes matter or not turns on whether you are a day trader (then they matter) or a long-term investor (the temporary crazy prices don’t matter to the long-term investor because they don’t remain in effect for long).



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