The Bright Side of Volatility

Roller Coaster

Stock markets around the world have had a bumpy ride so far in 2016. The CBOE Volatility Index (often called the “VIX”), a measure of expected stock market volatility, has doubled since early November, and US stocks have fallen more than 10% since the start of the year. These kinds of changes can be gut-wrenching and can make it difficult to maintain a long-term perspective. But for some investors who are able to do so there’s a bright side to volatility.

If you’re periodically investing money, such as putting a portion of each paycheck into a 401(k) account, volatility isn’t necessarily bad. When markets fall you’re able to acquire more shares, giving you “more bang for your buck.” This concept is similar to “dollar-cost averaging,” where the average price you pay for an investment will be less than the average of the prices at each of the times you’re investing (because you’re acquiring more shares when the price is low and fewer shares when the price is high). Compared to if markets just blandly moved in a straight line, the ups and downs allow your periodic investments on average to go farther.

Of course there are a few caveats to this volatility fairy tale. First, it assumes that the market will end up in the same place regardless of how much volatility there is. This assumption is clearly sometimes false; stock markets would almost certainly be higher right now if the beginning of this year had been a paragon of financial tranquility. But over the long term it’s approximately true. Stock prices 20 years from now are unlikely to be massively affected by how much stock market volatility there was in 2016.

Second, the potential benefits of volatility only apply if you have a long time horizon for your investments. If instead you need the money in the near future and markets plunge, the fact that you can then get more bang for your buck won’t do much good.

Perhaps the most important caveat, however, is that you need to be able to stick to your strategy of periodically putting more money into the market. When the kind of turbulence that’s characterized stock markets this year arrives, it can be tough to invest money knowing that one wild day of market moodiness might eliminate a chunk of it. But those who are able to continue making periodic investments can benefit in the long run.