On January 2nd, the stock market in the UK as measured by the FTSE All Share Index opened at 3,159. A year later it closed at 3,609. It was a very volatile year.

Sorry: what’s that you asked? How could a year in which the market went up 14% be characterised as “volatile”?

Well, how would you describe it?

If it had as suddenly gone down 14%, you’d certainly have called it “volatile,” would you not? But one senses that this is not the adjective which springs most readily to mind when you’re considering an absolutely glorious year like the one just passing away. And what ought we to infer from that?

I for one infer that we may have a somewhat inconsistent definition of “volatility” – one that is potentially very unhelpful to your chances of success as an equity investor. Because you may be (however unconsciously) defining “volatility” as “down a whole lot in a big hurry,” without realising that a terrific leap forward such as that we experienced in 2013 is equally volatile – just in the opposite direction. They are two aspects of the same phenomenon.

Volatility defined

Properly considered, the term “volatility,” applied to prices and values in general and to the equity market in particular, simply means “tending to fluctuate sharply and regularly.”  There’s no implication of “down” versus “up” there at all. The fact is that equity prices have tended to fluctuate – sharply and regularly, up and down, throughout history. Indeed, it is exactly their volatility – those sharp and regular divergences, both up and down, from their long-term trend – which explains equities’ premium return.

The long-term compound return of shares in the UK is very nearly 12% per year. Consider the historical inflation rate of 5.5% and one discovers that the long-term real return of equities has historically been more than twice that of inflation. Why? you ask. Volatility, I answer.

And here I’m simply using the word volatility as a synonym for uncertainty – which, properly speaking, is all it is. It is the vexing uncertainty of equity returns in the short to intermediate term – they can be up 20% one year and down 20% the next, take away equities’ greater volatility and in time their greater return must also disappear.

Embrace it!

Follow this logic, and the rational investor must not only accept equity volatility: he must embrace it.

And why would he not? Just since 1980, the average annual intra-year decline in the FTSE All Share Index has been very nearly 16%. Indeed, since the beginning of 1986, the Index has declined 5 times as follows (in round numbers, and ignoring dividends): 37%, 25%, 30%, 31% and 43%. That’s pretty terrific volatility, wouldn’t you agree?

Well, I would, too. But then I’d go one step further, and remind you, dear reader, that the FTSE came into 1980 at about 240, and went out of 2013 somewhere north of 3,600.

Nothing – absolutely nothing – about equities’ past proves or predicts anything about their future. But I think I can offer one fairly educated guess about the past. People who got alternately euphoric and then panicked by the volatility (up and down) around the trend line probably ended up with less favourable investment results than did people who simply stayed relentlessly focused on the trend line itself.

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