Although share prices have become increasingly volatile, long-term investors can safely ignore the market's day to day indecisiveness.
For a long-term investor, the short term ups and downs in share prices that cause so much grief for those who think volatility is something to be scared of is really of no consequence.
Proponents of modern portfolio theory seem to spend a lot of time worrying about the minutiae of diversification, volatility, and other things that don't seem to bother most long-term investors.
While diversification makes sense if you want to avoid the risk of one specific sector being able to seriously damage your portfolio if it crashes, do we really need all the complex maths shown in the Wikipedia article I linked to earlier? At a pinch, I guess fund managers who have specific quantifiable diversification targets that they need to justify to their bosses might need it, but for the rest of us just picking a few shares from different sectors is really all we need. And we can leave all the maths for the next budding hedge fund guru working on his PhD thesis.
Is volatility so bad?
But while diversification does make some sense, the measure I really think is useless for long term investors is volatility. If we invest some money in the stock market today, and sell our portfolio some time in the future, our profit will only depend on two things -- the prices when we bought and the prices when we sold. But portfolio theorists seem to attach great importance to the wiggliness of the line on the chart that connects those two points.
I'd like to make a prediction here. Over the next four days, I can confidently predict that the FTSE 100 will not budge. If we draw a line from the close of the market tonight until the opening on Tuesday morning, it will be a straight line showing no volatility at all.
Yes, that's because the markets will be closed for the Easter holidays, but would it have made any difference on any other four days if you just ignored the intervening days and drew a straight line from the start to the finish?
It's only a short-term thing
It would only make a difference if you didn't want to keep your shares for the full four days, and instead wanted to sell them on one of the intervening days. So in that sense, volatility is a concern in the short term. The more wiggly the share price chart (i.e. the more volatile the share), the more likely it is that the price will be down on the day you want to sell it (and conversely, the more likely it will be well up). And markets can be very irrational in the short term.
But supposing I told you that you could choose a long-term portfolio today, and then the markets would be closed for 10 years. Companies would carry on with their business, reporting their results every quarter (and for the sake of simplicity, we'll assume none of them goes bust, gets taken, over, or changes its nature in any substantial way). Then in 10 years' time, the markets will open and set a valuation based on the company at that time.
Would you be any better off or worse off had the markets been open, with all their usual volatility, for the 10 years? What difference would it make if the share price chart was a straight line between now and then or a cross-section of the Alps? None, not for a long-term-buy-and-hold investor.
It's all in the mind
The market is not going to close for ten years, of course, but what if you just pretend it will? Buy what you consider to be good companies that you want to keep for the long term, and buy when you think the price is cheap. Then keep a check on them not by looking at the share prices, but by following their actual commercial results, and only start checking the share price when you're getting closer to wanting to cash them in.
You'd probably do just as well as if you followed the share prices every day, and with a good bit less stress.
So that's what I reckon we long term investors should do -- concentrate on the fundamentals of the companies we want to buy, and leave the worrying about short term volatility to those who think they can time the markets, to people who think day trading is a neat idea, and to the residents of the ivory towers of academia. (Oh, and peek at the share price every now and then if we really want to, but let's not get stressed about it).
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