Daily Update: Risk Versus Reward

The VIX jumped another 4% this morning and has now spiked 39% YTD. It’s getting a little wild out there, which makes this an apt moment to reset our sense of how much fear is justified and what is actually healthy.

After all, nobody likes volatility. We only tolerate wild market swings when they stack up to the upside . . . and even then, those returns need to compensate us for the risk we accept along the way.

There needs to be a reward at the end of the rollercoaster. If there isn’t, the market is seriously broken.

And as always, risk tolerances and return expectations are in the eye of the investor. You don’t have to settle for what “the market” provides.

You can pick your spot on the risk-return curve. Right now, I think we have a real divergence between short-term risk and long-term returns that ambitious, brave and patient investors can exploit.

Start with the S&P 500. As we’ve discussed, the market as a whole isn’t actually swinging as far as the elevated VIX suggests.

Real volatility is only a little more intense than “normal.” But the VIX at this level makes people think we’re facing a once-in-a-decade storm.

It’s a gut check. And there’s little reason to think that “normal” volatility will lead to returns better or worse than what generations of investors have enjoy.

The S&P 500 usually trades in a 15-17% channel in any given year. That’s often some combination of 8-12% in upside and 5–9% in downside . . . a lot of rally punctuated with a correction now and then.

If that’s too wild a ride for you, you might need to adjust your return expectations. But keep in mind that all that dread in the present is creating a lot of noise in the market.

For one thing, the real clouds hanging over some corners of Wall Street are making it hard for investors to recognize the sunshine elsewhere.

Whenever people talk about “unsustainable valuations” and the threat of rising interest rates, they’re largely talking about the kind of growth stocks that dominate the NASDAQ. They’re volatile in the short term but the long-term expansion rates are compelling enough to cut through the chatter and pay off big over time.

But while¬†these stocks are also heavily weighted in the S&P 500, there are still plenty of more mature and less speculative companies to provide ballast. They’re good companies. They simply aren’t growing fast or taking big chances.

Needless to say, they’re less volatile. Wall Street knows what they’re worth, more or less. The only noise on their charts is what echoes in from the NASDAQ . . . and in that respect, it’s truly just noise, sound without fury.

Admittedly, there’s roughly 40% overlap between the two indices, but that means that about 60% of the S&P 500 is not part of the NASDAQ and vice versa.

Factor the NASDAQ out of the S&P 500 and the “mature” end of the market has actually been 30% less volatile than normal lately. It’s calm and even cheerful over there.

The NASDAQ is where the short-term storms are gathering. If you don’t like thunder and lightning, it’s time to steer clear of those stocks.

But if you aren’t afraid of a little weather, you need to ride the rollercoaster to get to the good rewards. Over the long term, growth rates overcome even the most spectacular disappointments.

The wins more than balance out the losses. And after the first few wins, the wild ride feels more exhilarating than enervating.

Go back 20 years to when the NASDAQ was still wounded in the wake of the dot-com crash. Big Tech was comatose. The stocks were dead money.

Since then, that end of the market has soared 750% across roughly double the level of ambient volatility that investors were willing to tolerate on the “quiet” end of Wall Street.

That volatility level isn’t much above what the S&P 500 as a whole is weathering now, so if this is too wild a ride for you, tech stocks were never going to be your long-term friends.

There are plenty of other stocks to suit your tolerance. But if you’re looking for more than about 7% a year, you need a little nerve.

No guts, no glory . . . right?