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Equity Volatility for You

Most of you have probably already read Mark’s August 2nd Commentary entitled “Equity Valuations”. If you have not read it, I highly recommend going to Mark’s blog and reading it.  In keeping with that longer-term investing theme, I wanted to build on that particular Commentary. Specifically, I would like to focus on determining what type of equities are right for you.  Whenever the market goes through one of its inevitable rough periods, many investors start to question whether their stocks will ever “come back”.  One of the key points Mark mentioned in his Commentary was if you are someone who wanted to sell (or did sell) after the market was down substantially, then stocks may not be the proper investment vehicle for you.  Each individual needs to perform an honest self-assessment to determine if stocks are the right type of investment for your specific needs and temperment.   Assuming equities are going to be at least a part of your overall portfolio, we need to drill down into just what type of stocks you should own.  For simplification purposes, we will assume there are two basic types of equities, high beta (higher volatility) and low beta (lower volatility). 

In general, you will find that higher beta stocks are found in industries that have above average long-term growth prospects (technology and biotech companies, for example).  The companies that operate in these high growth industries can grow extremely fast (Apple), but they also face the almost constant threat of new companies making their business models obsolete (Palm).  So, the stock prices of these types of businesses tend to fluctuate substantially, both up and down.  These businesses also tend to retain most (or all) of their earnings for future growth opportunities so current dividends tend to be very low.  Most of the stock return in the long-run will come from capital appreciation, not dividends.

At the other end of the spectrum, there are the slower-growing, lower-beta stocks.  Generally known as “Blue Chips”, these are the stocks that most of us have heard of (Pepsi, Johnson & Johnson, Kraft, for example).  These businesses are generally very established in their industry, and their threat of obsolescence is quite low.  Most of these companies have fairly stable, but low, growth rates.  The stocks tend to pay a pretty good dividend since the companies don’t need all of the cash flow to reinvest in their business.  Generally, in the long-run, somewhere around half of an investor’s return will come from dividends, the rest from retained earnings.  The dividend yield generally helps to provide a cushion during market pull-backs.

So the question becomes, are you someone who is comfortable with the substantial ups and downs of higher beta stocks (our Best Ideas portfolio is similar to this) in order to target a higher than average long-term return, or are you more comfortable with the lower volatility of the blue chip equities (our Blue Chip portfolio) with the realization that your long-term returns will likely be lower?  The answer to this question is very important.  Both types of equities will have their day, but they tend to work somewhat inversely of one another. 

It is much better to figure out ahead of time what you are comfortable with, not after a large pull-back in the market.  If you have a long-term investment timeframe (years, not months), and can stick out the inevitable rough periods, then the more aggressive approach will most likely pay off in the end, but you need to stick with it.  If you believe you will feel the need to switch into a more conservative investment, like blue chips, after the aggressive portfolio has underperformed in the short-term, then you will be better off sticking with blue chips from the start.  You may give up some return in the long-run, but you will sleep better at night and stick with it.  Sticking with a long-term investment plan, through good times and bad, is probably the most important part of successful investing, but it is certainly not easy to do.