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Markets

The Upside of Risk

If you want higher returns, you have to accept the thrills and spills that accompany them.

Investors this summer got a rude taste of something many of them had forgotten: volatility. Knowing what a stock (or any other investment) returns over time is not enough. You need to know how consistent those returns will be. Think of a baseball player who hits .198 one year, .376 the next and .280 the next. Computing his three-year batting average of .285 tells you little about the volatile, inconsistent nature of his hitting.

Measuring the jolts. A common measure of stock volatility -- that is, the extremes of the market's ups and downs -- is standard deviation, an expression of how much prices vary from their own average movement. History shows that the standard deviation of the U.S. market as a whole has been about 20 percentage points. Because stocks (using Standard & Poor's 500-stock index as a benchmark) have returned an annualized average of about 10%, two-thirds of the time we can expect S&P returns to range between -10% and +30%. Lately, however, returns have fallen into a much narrower range. For the four years starting in 2003, the S&P returned 29%, 11%, 5% and 16%. For the three years that ended last June 30, the standard deviation of the S&P was a mere 7. No wonder investors had gotten used to smooth sailing.

Why have returns been so steady? One factor is the U.S. economy's recent consistency, with low inflation, steady interest rates and a gross domestic product that has risen within a narrow band since 2003 at annual rates of 2.5%, 3.6%, 3.1%, 2.9% and (for the first half of 2007) 2.3%. But in midsummer, problems showed up in the mortgage market that raised serious uncertainties.

As measured by the Chicago Board Options Exchange's Volatility Index, or VIX, the volatility of the stock market suddenly became more violent in July. The VIX, which uses a complex algorithm to measure investors' expectations of near-term volatility, declined for four straight years starting in 2003 and finished 2006 at a record low. By early September, however, the index had nearly doubled, which means that investors were riding a roller coaster and expecting more stomach-churning adventures to come.

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A stock's price reflects the present value of its future earnings. Those earnings depend on the course of the economy, and investors became unsure of what to make of that course. It looked bright one day and dim the next, so prices bounced wildly. In addition, market psychology, which in the short term can have little to do with facts or calm analysis, exacerbates volatility. Yale economist Robert Shiller began his 1992 book, Market Volatility, with a quotation from the 18th-century novelist Henry Fielding: "Fashion is the great governor of the world; it presides not only in matters of dress and amusement, but in law, physics, politics, religion, and all other things of the gravest kind." For stocks, fear became fashion.

In part, the new volatility was a numerical illusion. On August 9, for example, the Dow Jones industrial average dropped 387 points. That sounds like a lot until you realize the loss was 2.8% -- or equal to just a 70-point decline in 1990. But mostly, the renewed volatility is normal. It's the way the stock market works. And, believe it or not, it's a good thing.

Reward for risk. Imagine a world in which stock investments performed the same year after year. A stock would be like a certificate of deposit. It would have no volatility -- except for the effects of inflation -- but it wouldn't put much money in your pocket, either. Stocks have returned an annual average of more than 10% over the past 80 years because they are volatile. To put it another way: A higher return is your reward for investing in a riskier asset.

You have to work to make money in the stock market. To a small degree, the work entails picking good companies or good mutual funds. But most of the work is enduring the anxiety and fear of owning something that could be worth a good deal less tomorrow than it is today. The challenge is to hang on to good firms through thick and thin.

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For that reason, I have little patience for investors who whine about the volatility of the Dow or the Nasdaq. If you're risk-averse, you can put your money in plenty of places, including Treasury bills, short-term notes and money-market funds. But if you want higher returns, you have to accept the thrills and spills that accompany them.

Warren Buffett said nearly 30 years ago, "Uncertainty, actually, is the friend of the buyer of long-term values." Volatility has two beneficial effects. It not only keeps the overall historic returns of stocks in the double-digit range, but also provides smart investors with the chance to buy excellent companies when they are cheap.

Buying on dips. Again, imagine a world in which a company such as Johnson & Johnson (symbol JNJ) traded every day at nearly the same price, slowly inching up a few percentage points a year. As an investor, your ride would be smooth, but you would never have the opportunity to buy a bargain. Over the past four years, however, the stock of even this relatively stable company has bounced between about $45 and about $67. All that time, J&J has been the same company, doing business in the same global economy. But investor expectations -- influenced by the effects of enthusiasm and fear -- have at times boosted the stock price and at other times depressed it.

If you are an investor who loves the company, and you want to own it for the long term (as you should), then you should be a buyer when volatility drives J&J's price down. In early September, by the way, J&J's price-earnings ratio, based on expected profits over the next 12 months, was 14, according to Yahoo Finance. That's an earnings yield (earnings divided by price) of more than 7%. By contrast, ten-year Treasury notes recently yielded just 4.5%. That's the definition of a very nice deal.

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In general, the volatility of the U.S. stock market has two characteristics you can exploit. The first is that the market is less volatile over longer periods. For example, over the course of just five trading days last August, the S&P fell 90 points, or 6.3%. But for the entire month of August, the S&P was actually up by 1.3%. In July, the worst month of the summer, the S&P fell 3.2%. Or go back to Black Monday. On October 19, 1987, the Dow fell 23% in a single trading session. But for the entire year, the Dow was actually up 2%, not including dividends.

The longer you hold on to stocks, the more volatility declines. Research by Ibbotson Associates found that, since 1926, the U.S. stock market (as represented by the S&P 500 and its predecessor) lost money an average of every three to four years. That's not a pleasant prospect. But Ibbotson found that losses occurred in only about one in eight five-year periods. Over 15-year periods, stocks scored positive returns every time. Standard deviation? For ten-year holding periods, it drops to just 5.

Spread your risk. The second way to exploit volatility is to dampen it through diversification. Between April 1999 and December 2000, Priceline.com lost 99% of its value. On March 7, 2000, one of the most stable businesses in the world, Procter & Gamble (PG), dropped 30%. Bad things happen in the stock market, and the shocks come out of the blue. The best way to guard against them is through diversification. True, by owning a lot of stocks (or an index fund or a broad mutual fund), you limit your upside. But for most investors, it's a good trade-off. If history is a guide, you'll get double-digit returns on average, and volatility will be manageable.

Beware, however, of mutual funds that produced spectacular returns in recent years. Practically the only way a fund manager can do that is by taking risks that will become unacceptable for most investors over time. I worry, for example, about a fund like Janus Orion, which has returned an annualized 23% over the five years ended September 14 -- fully ten percentage points per year better than the S&P. A great record, for sure, but the fund is super-concentrated: Just ten stocks account for 45% of its assets.

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Even the volatility of an S&P index fund can be tough for many investors to bear. Just remember that playing the stock market is like taking a random walk: No one, but no one, knows where the next step will be. It is a good bet, however, that in the long term (over five years or more), owning shares in fine companies -- or in the U.S. market as a whole -- will pay off. Just hang in there.