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Volatility is the Price Investors Must Pay to Enjoy Attractive Returns

May 8, 2017

A bedrock investing principle is that a trade-off exists between risk and reward.

An investor who desires a high rate of return must be willing to accept the risk of loss. On the flipside, investors who are unwilling to accept risk cannot expect an attractive rate of return. Any purported exceptions to this rule are almost always too good to be true.

This relationship is illustrated in the table, which compares calendar year returns for stocks versus the largest declines experienced each year. The S&P 500 has gained nearly 10% on average since 1980 and is up in 28 of 37 years (76% of the time). However, investors participated in those gains only if they were willing to endure yearly losses of 14% on average.

The trade-off is even starker for small cap stocks, a riskier area of the market. Small caps enjoyed a very attractive average return of 12%, but suffered an average loss of nearly 18%. To put that in perspective, the conventional definition of a bear market is a 20% loss.

Indeed, volatility is the price investors must pay if they want to enjoy long-term gains. Accordingly, investors should come to expect short-term losses and treat them as a normal part of investing.

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