What is the best way to deal with volatility? Short answer, discipline. Discipline equals freedom. If you haven’t heard about Jocko Willink yet, do yourself a favor and check him out on Youtube. Better yet, check out any of his books, one of which is entitled Discipline Equals Freedom: Field Manual.
Short intro. Jocko is a retired navy seal officer and a bad-ass who now spends his time speaking, teaching, podcasting, and consulting. Jocko talks a lot about discipline, and since we talk about discipline a lot on this site, we thought it’d be fun to write two small posts dedicated to discipline in investing. This is part one.
Discipline can be a solution to so many life problems. Want to get fit, discipline. Want to improve your life, discipline. Want to make more money, discipline. One area where discipline is crucial is investing. Not having discipline has led to funds being shut down, investments entirely lost, bubbles created and burst.
Discipline and market fluctuations
Markets of any kind are volatile places. A market is a place where people come to buy and sell small pieces of companies, debt obligations, commodities, and many other simple and complex financial products. Just like any market, there is supply and demand for these goods. Whether natural or artificially created, changes in supply and demand will determine the price.
Let’s take bonds as an example. Long-term bonds that are considered “safe” investments may have relatively wide price swings. When interest rates go up in the market, the price of bonds goes down. The stock portion of any portfolio will almost certainly fluctuate over several years.
Market fluctuations, however, are good as they create opportunities for us. When prices go up, the value of our portfolios goes up, and we become wealthier on paper. When prices go down, we are presented with an opportunity to purchase something at a lower price and have the potential to earn a more significant return in the future.
But there is a genuine danger that this opportunity-seeking turns us into speculative gamblers. This is where discipline comes in.
What is the best way to deal with volatility? Fluctuations guide investment decisions.
There are ways to profit from these fluctuations if you are disciplined. Fluctuations can guide our investment decisions. But these decisions are, in most cases, will be decisions to stay inactive rather than take some action. We will be tempted to do two things during these fluctuations: time the market or figure out the true value of the companies we hold.
By timing, we mean anticipating the future course of the market and either buying or selling to capitalize on the forecast.
By pricing, we mean understanding a company’s fair value and buying it when the market price is below fair value and selling it when the price is above.
If you decide that timing, the market is the way to go; You inevitably will become a speculator. The investment industry prays on institutional and professional investors to succumb to this need for market forecasts. There is a lot of money tied to the industry. Equity researchers, brokers, investment banks, and investment firms with in-house research arms all boast how their forecasts are the most accurate. The simple truth is you are expecting to be better than everybody else while following a market forecasting system that everybody else is following. It is possible, don’t get me wrong. A handful of incredible research services find undervalued gems more often than not, but these services are rare.
Timing also has psychological significance. For speculators, timing is everything. The idea of waiting a year to see a return on investment can be very frustrating. Some timing signal tells you to sell and take profits, and you cheer that you made a quick return, and then the money sits uninvested until you find another signal that it is time to buy something else. How trustworthy are these signals? Especially if they are daily, weekly, or monthly.
Pricing. If you hold few stocks, it is entirely possible to use some methodology to try and figure out the true value of the business you are holding. This is not an easy task, however. For an individual investor with no prior knowledge of finance, you have to rely on 3rd party tools or people to do that. If you hold an all ETF portfolio, it will be impossible to understand the fair value of all the companies in your portfolio. So what should you do?
You are better off riding out the volatility.
Instead of jumping in and out of your positions, causing you anxiety and fear, you are much better off just doing nothing. Let’s take a look at 2008 as an example. If you invested during the worst time possible and bought some S&P500 for yourself, did not diversify with bonds, it would take just under two years for the whole portfolio to recover, and then you would 4x your investment over the next ten years. This also has been proven in financial literature a million times over.
Discipline is key.