The November 2007 issue of Kiplinger’s has a great article from James K. Glassman called “The Upside of Risk”. Glassman’s explanation of market risk is wonderful. Normally, I’d post an excerpt from the online version of the article and then point you to it, but I can’t find this piece anywhere on the web. Instead, I’ll post a longer excerpt than normal.

Imagine a world in which stock investments performed the same year after year. A stock would be like a certificate of deposit. It would have no volatility — except for the effects of inflation — but it wouldn’t put much money in your pocket, either. Stocks have returned an annual average of more than 10% over the past 80 years because they are volatile. To put it another way: A higher return is your reward for investing in a riskier asset.

You have to work to make money in the stock market. To a small degree, the work entails picking good companies or good mutual funds. But most of the work is enduring the anxiety and fear of owning something that could be worth a good deal less tomorrow than it is today. The challenge is to hang on to good firms through thick and thin.

For that reason, I have little patience for investors who whine about the volatility of the Dow or the Nasdaq. If you’re risk-averse, you can put your money in plenty of places, including Treasury bills, short-term notes and money-market funds. But if you want higher returns, you have to accept the thrills and spills that accompany them.

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Again, imagine a world in which a company such as Johnson & Johnson (symbol JNJ) traded every day at nearly the same price, slowly inching up a few percentage points a year. As an investor, your ride would be smooth, but you would never have the opportunity to buy a bargain. Over the past four years, however, the stock of even this relatively stable company has bounced between about $45 and about $67. All that time, J&J has been the same company, doing business in the same global economy. But investor expectations — influenced by the effects of enthusiasm and fear — have at times boosted the stock and other times depressed it.

If you are an investor who loves the company, and you want to own it for the long term (as you should), then you should be a buyer when volatility drives J&J’s price down.

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In general, the volatility of the U.S. stock market has two characteristics you can exploit. The first is that the market is less volatile over longer periods. For example, over the course of just five trading days last August, the S&P fell 90 points, or 6.3%. But for the entire month of August, the S&P was actually up by 1.3%… The longer you hold on to stocks, the more volatility declines. Over 15-year periods, stocks [have] scored positive returns every time.

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The second way to exploit volatility is to dampen it through diversification… True, by owning a lot of stocks (or an index fund or a broad mutual fund), you limit your upside. But for most investors, it’s a good trade-off. If history is a guide, you’ll get double-digit returns on average, and volatility will be manageable.

As I’ve said before, historically the stock market has provided solid returns over the long-term. It does have a lot of short-term volatility, though. If this volatility bothers you, you ought to keep your money in safer investments until you’ve had a chance to educate yourself on why “risk” isn’t always a bad thing.

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