The prolific Fidelity portfolio manager Peter Lynch once famously said that “the real key to making money in stocks is not to get scared out of them.”

As I write, the equity markets (as measured by the S&P 500) are enjoying year-to-date gains of around 6%, a modest yet welcomed result.  The Nasdaq index is up over twice that amount, climbing just over 14% since the beginning of the year.  (Less modest and more welcomed.)

Coming off the losses we experienced from October 2007 to March 2009, it’s certainly been a plus for those in my line of work and for the clients we serve to see the markets recovering some (not all) of those losses, no matter the stalled recovery and seemingly constant economic uncertainty.

Whatever the current condition of the market, it seems like a good time to acknowledge the fact that volatility – up or down – is a constant, while gain and loss will forever be taking turns acting upon client portfolios.  Volatility itself has no bearing on whether or not we make or lose money within our portfolios.  Selling determines that.  Knowing this, it is important to distinguish between volatility and loss, and to reinforce the fact that they are not the same thing.

I would venture to say that clients of Milestone Financial typically have a higher-than-average level of acceptance concerning volatility; that is, they have been asked to identify the margin of volatility they can accept, knowing that, in general,  for every tick up or down on the volatility scale there is a corresponding amount of gain or loss which they can expect when it comes time to sell.  Setting an investment policy which relates (among other things) to “volatility”, clients tend to be more patient when portfolios experience a “loss”.

In any case, it may be useful to clients and non-clients alike to illustrate the loss-volatility distinction by way of Warren Buffett, who controls Berkshire Hathaway Inc:   to wit: what result did three cataclysmic market events have on Berkshire Hathaway stock, and what was his response as an investor during each of them?

On October 19, 1987, the date of the single greatest one-day crash in stock prices in American history, Buffett’s personal shareholdings in Berkshire Hathaway declined by $347,000,000.  That’s the amount he “lost” in one day.

But he didn’t sell, therefore he technically didn’t “lose” anything.

Then, between July 17 and August 31, 1998, he “lost” $6,200,000,000.  Yes, that’s six billion, two hundred million dollars.

Still he didn’t sell.

Finally, between the October ’07 market top and the March ’09 bottom, Warren Buffett “lost” approximately $25 billion dollars.  But of course, he didn’t sell even then.

When asked by a CNBC personality subsequent to March ’09 how it felt to have lost 40% of his lifetime accumulation of capital, his response was that it felt about the same as it had the previous three times it had happened.

Here’s the instructive part:  during the period of time between the first and second of these events, Berkshire Hathaway stock grew from $3,170 per share to $60,500 per share.  Between the second and third, the share price grew from $60,500 to $73,195.  On October 29 2010 Berkshire shares closed at $119,300.

Granted, this is probably the most extreme example one could find regarding the negative correlation between loss and volatility, but that doesn’t make it a bad example, and it certainly doesn’t make it wrong.

The key to coping with volatility is to understand it in the context of loss.  Volatility has been a constant in equity markets since there’s been equity  markets, and it is here to stay.  All by itself, volatility does not determine the amount or the severity of loss (or gain for that matter) of capital.  For that to happen, investors must behave in certain ways.  Reacting to volatility is natural.  Indeed, it would be difficult not to have an emotional response to the decline in the value of your portfolio (especially a severe one) as most of us experienced over the last decade or so.

The challenge is to not react to volatility by abandoning the tenants that led you into the markets in the first place, but to recognize it as an inevitable part of the investment process.  Volatility cannot be controlled, but our response to it certainly can.

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