Volatility Is Your Friend

On January 25th, 2017 the Dow Jones Industrial Average closed above 20,000 for the first time ever.  What does that mean and should we care?

First of all notice that an index is an average and how the average is composed has meaning. The Dow Jones Industrial is the average of the 30 largest businesses traded on American stock exchanges . At one time they were industrial stocks but now include banks, retailers and a service like VISA. Interesting, but not harmful. A decent indicator if big businesses represent the economy.

The 20,000 value above, is the raw price index and does not account for dividends earned and reinvested.  The total return index is more useful to watch because it is more like how investors behave. The flaw is it is not adjusted for taxation and costs. Even with those defects, we can use that information to help us understand how investments grow.  The total return index closed over 42,275 on the 25th.

In the 30 years ended now, the total return index is up on average 10.679% annually. Quite a lot happened in that period. Two wars in Iraq, 9/11, the 1987 market crash, the dot com bubble, the internet, high velocity trading, and online trading.  Pretty chaotic.  At the beginning the index was about 2,000.  I’ll bet you would have guessed that wrong.

Maybe 10.679% is too high. What about 1957 to 1987. High inflation, stunning interest rates in 1980-81, the oil crisis, the war in Viet Nam, Kennedy assassination, the end of the gold standard, the war on poverty, the 1957 recession.  Pretty normal.  Average return 9.563%

Okay then, really bad things.  What about 1927 to 1957? The roaring twenties, the great depression, the “New Deal,” World War II, returning service people, the military industrial complex. Average return was 9.298%

The economy is quite resilient over long periods so maybe we should have some faith and stop worrying about what happens on a Thursday. Where will that thinking lead us?

Suppose we believe the future is at least a little like the past.  No guarantees and especially none in the short run. If we guess that over long periods future total Dow returns will be 9.5% before taxes and fees, when will the total return index be over 1,000,000?

12,732 days from the 25th of January 2017.   4 December 2051.

As you would expect, the no dividend index grows more slowly.  6.7% is a decent guess for its future.  It will rise from 20,000 and reach 1,000,000 on 17 July 2085.

As you can see, you can do anything you want with numbers.

Numbers obscure as much as they illuminate unless you know what to notice. In the case of stock market indices notice that they represent the wealth producing part of the economy. If you think about it a bit you will see that the wealth producing part is unlikely to go away. It will change,  but people adapt. Like VISA is now an industrial. Something will be there.

In the wealth producing part of the economy, the easy part to keep track of is business.  A business has two values and that is the source of variability.  As some perceive it, risk. The values are 1) what the businesses are really worth, which on a given day, no one knows, and 2) what people think they are worth that day, the market price.

You may have noticed that when people work with things they don’t fully understand, they get it wrong.  Worse no two of them get it wrong the same way. That is why prices go up and down far more than people enjoy. Over long times, people’s opinion of value doesn’t matter and the true business value shows through.

Now if you know the long run for the stock market is reasonably stable and you have a long run left, why would volatility matter to you? Who told you it should? Believing faulty information costs.

For all you 60-year-old couples out there, there is a better than 50-50 chance that at least one of you will still be alive in 30 years. You don’t have to be 35 to have a 30 year time frame. Unless of course, you care going to spend all of your retirement money on your 65th birthday. Could happen.

Know the meaning of numbers and know the context of your situation.  For people who understand the long run and risk, volatility is a friend.  It provides buying opportunities.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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