16. Why You Shouldn’t Fear Volatility

The price of admission for successful investing

FRED SMITH WAS at his wit’s end. He had already sunk most of his net worth into starting a package delivery company called Federal Express (later FedEx) and he had just been denied additional funding from General Dynamics, his previous funding partner.

It was Friday and Smith knew that he had to make a payment of $24,000 the following Monday for the coming week’s jet fuel. There was just one problem — Federal Express only had $5,000 in its bank account.

Smith did the only rational thing he could think of—he flew to Vegas and gambled the remaining $5,000 playing blackjack.

When Monday morning arrived, Roger Frock, Federal Express’s General Manager and Chief of Operations, checked the company bank account and was in shock. Immediately Frock confronted Smith and asked what had happened.

Smith confessed, “The meeting with the General Dynamics board was a bust and I knew we needed money for Monday, so I took a plane to Las Vegas and won $27,000.”

That’s right. Smith had gambled the company’s last $5,000 playing blackjack and won big.

Still in shock, Frock asked Smith how he could risk the company’s last $5,000 in such a way. Smith responded, “What difference did it make? Without the funds for the fuel companies, we couldn’t have flown anyway.”92

Smith’s story illustrates an important lesson about risk and the cost of inaction — sometimes the biggest risk you can take is taking no risk at all.

This is especially true in investing. Though the financial media will often mention when a hedge fund blows up or a lottery winner goes bankrupt, how often do they discuss the person sitting in cash for decades who fails to build wealth? Almost never.

The issue is that those who play it safe don’t see the consequences of their actions for many years. But those consequences can be just as damaging as the consequences of taking too much risk.

Nowhere is this more evident than when examining market volatility and those who try to avoid it. Because avoiding too much downside can severely limit your upside.

Therefore, if you want the upside—building wealth—you have to accept volatility and periodic declines that come with it. It’s the price of admission for long-term investment success. But how much should you accept? And what is the price of admission?

This chapter uses a simple thought experiment to address this.

The Price of Admission

Imagine there exists a market genie who approaches you every December 31st with information about the U.S. stock market for the next year.

Unfortunately, this genie cannot tell you which individual stocks to buy or how the market will perform. However, the genie does know how much the stock market will be down at its worst point in the next 12 months (the maximum intrayear drawdown).

My question to you is: How much would the market have to decline in the next year for you to forgo investing in stocks altogether to invest in bonds instead?

For example, if the genie said the market would be down 40% at some point next year, would you stay invested or sit it out? What about down 20%? Where’s your limit?

Before you answer the question, let me provide you with some data so that you are better informed. Since 1950, the average maximum intrayear drawdown for the S&P 500 has been 13.7%, with a median drawdown of 10.6%.

This means that if you had bought the S&P 500 on January 2 of any given year since 1950, half the time the market would be down by 10.6% (or more) from the start of the year and half the time it would decline by less than 10.6%. On average, the market declines by about 13.7% at some point within a given year.

The first plot illustrates the maximum intrayear drawdown for the S&P 500 since 1950.

As you can see, the worst decline occurred in 2008 when the S&P 500 was down 48% on the year in late November.

After seeing this data, at what level of decline would you choose to sit things out?

Let’s start by assuming you go ultra-conservative with your money. You tell the genie that you would avoid stocks in any year where there was a drawdown of 5% or more and invest in bonds instead.

We will call this the Avoid Drawdowns strategy because it invests all of its money in bonds in years when stock drawdowns are too high (in this case 5% or more) and moves that money to stocks in all other years. The Avoid Drawdowns strategy is either entirely in bonds or entirely in stocks in any given year.

If you had invested $1 in the Avoid Drawdowns strategy from 1950–2020 (while avoiding all years with 5% drawdowns or greater), it would have cost you dearly. By 2018 you would have 90% less money than if you had owned stocks the whole time (“Buy & Hold”). The following chart illustrates this situation (note: the y-axis is a logarithmic scale to better illustrate changes over time).

The reason you underperform Buy & Hold is simply because you are out of the market too often. In fact, you would spend 90% of all years (all but seven since 1950) in bonds.

You can see this by looking at the next plot which highlights (in gray) when the Avoid Drawdowns strategy is in bonds. Note that this plot is identical to the previous plot except I’ve included gray shading when the Avoid Drawdowns strategy is invested in bonds.

As you can see, since you are in bonds so often, you rarely participate in the growth of the stock market. By taking no risk at all you end up underperforming Buy and Hold by a significant amount.

Avoiding drawdowns of 5% or more is obviously too safe of a route to take, so what if we went to the other extreme and only avoided drawdowns bigger than 40%?

If you did so, the only year you would have been out of the market since 1950 was 2008. This is the exact point when the Avoid Drawdowns strategy differs from Buy and Hold, as shown in the next chart.

While the Avoid Drawdowns strategy (gray line) does beat Buy and Hold (black line) over time, it doesn’t beat it by much. It can do far better if it was more conservative.

How conservative should it be? What size drawdown should you avoid if you want to maximize your wealth?

The answer is 15% and above.

Investing in bonds in years when the market declines by 15% (or more) and investing in stocks in all other years would maximize your long-term wealth.

In fact, if you were to be in bonds in each year when the market declined by 15% (or more), you would outperform Buy and Hold by over 10x from 1950–2020.

The next plot shows Buy and Hold versus the Avoid Drawdowns strategy when the Avoid Drawdowns strategy avoids drawdowns of 15% or greater.

This is the Goldilocks zone of drawdown avoidance. It’s not too risky, but it’s not too timid either. In fact, this strategy spends about one-third of its time in bonds when avoiding intrayear drawdowns of 15% or more. The next plot illustrates the time in bonds with gray shaded areas.

Increasing the drawdown threshold above 15% (e.g., 20%, 30%, etc.) gives you worse performance because you spend more time in stocks when they are more likely to lose money.


Because larger intrayear drawdowns for the S&P 500 are generally correlated with worse return performance by year end. Looking at a plot of annual returns against intrayear drawdowns for the S&P 500 illustrates this well.

As you can see, there is a negative relationship between intrayear drawdowns and annual returns. Those years that have big declines don’t usually end well for the stock market.

However, not all declines are bad. In fact, the S&P 500 has had a positive return in every year since 1950 with an intrayear drawdown of 10% or less.

There is No Magic Genie

This analysis implies that there is some level of intrayear decline we want to accept (0%–15%) and some level which we should avoid (>15%) if we want to maximize our wealth.

This is the price of admission for an equity investor. Because markets won’t give you a free ride without some bumps along the way. You have to experience some downside in order to earn your upside.

And, as the plots above illustrate, avoiding these bumps can be beneficial, though knowing when they will occur is impossible. Unfortunately, there is no magic genie.

What do we have instead?

We have the ability to diversify. We can diversify what assets we own and we can diversify when we own them. Buying a diverse set of income-producing assets over time is one of the best ways to combat volatility when it rears its ugly head.

More importantly, you have to accept that volatility is just a part of the game. It comes with the territory of being an investor. You don’t have to just take it from me, though. Consider the wisdom of Charlie Munger, Warren Buffett’s long-time business partner:

“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get.”

Munger, like many other great investors, was willing to stomach market volatility. What about you?

If you still fear volatility, then you might need to reframe your thinking on market crashes. For that, we turn to our next chapter.

92 Frock, Roger, Changing How the World Does Business: FedEx’s Incredible Journey to Success – The Inside Story (Oakland, CA: Berrett-Koehler Publishers, 2006).

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