When you are investing for the long term, beating inflation is necessary and equity (or stocks) is the right asset class.
While investing in equity, you have to be prepared for the volatility of stocks. This is the asset class risk which tends to reduce with time in the market but never goes away.
Please note that asset class risk is not the same as speculative risk taking. When people tell you (for example) that small caps are riskier and offer a higher return for that risk, they are usually referring to very short term speculative gains.
When markets turn volatile, as they sometimes do, avoid panicking. Keep calm, and keep stocking up equity assets. Risk is generally seen as the probability of a loss in any asset class. In finance, however, risk is usually seen as volatility in an asset class in relation to other asset classes, say, equities to fixed deposits. So, greater the volatility, riskier is the security—that’s the common theme.
By that yardstick, though, equities would be the riskiest of all asset classes. Yet, study after study shows that equity is one of the best long-term means of wealth creation.
Why, then, is there such a discrepancy in our perception of risk in equity as an asset class when it can offer some of the best returns?
The answer lies in understanding volatility. One of the common arguments of investors who do not want to invest in the stock market and seek alternative assets such as real estate is that short-term price movements can get too rough to handle.
Yes, that’s true. Equities are traded in the stock market daily, and millions of investors, including foreign and domestic institutions, not to mention the thousands of day-traders, generate such movement in stock markets. The sheer volumes coupled with the amount of fund flows create the turbulence and vast movement in stocks, sometimes daily. A huge institutional exit/entry can ruffle a stock price—and any investor, for that matter. That apart, fund flows into and out of the markets, too, have an impact.
Warren Buffett explained the concept of volatility and risk in his 2014 annual letter to his shareholders. “Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments—far riskier—than widely diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.”
What we should understand is that volatility in stocks is not the same as risk. Instead, real risk is the loss of purchasing power—that the Rs.10,000 in your wallet would be reduced to in the longer run. As Buffett says, holding cash is riskier than a stock portfolio built over time.
However, to be a successful investor, it’s not so much about managing your portfolio as it is about managing your emotions. In other words, don’t look at the red marks. Instead focus on the lower prices of equities—and the opportunities presented to pick up equity assets as if on sale.
Volatility is an inherent characteristic of equities. But that does not imply risk as most people mistakenly think and as explained by Buffett. In fact, one can reduce the perceived risk in your portfolio by accumulating stocks at lower prices whenever volatility plays out in the markets. At lower prices, one adds more units of equity assets in an equity mutual fund for the same amount of money.