2007-02-09 / Columnists

Focus On Financial Affairs

It All Depends…

Stephen J. Levine is an independent financial advisor. For more information on this topic, readers can contact him at 257 Beach 126 Street, Belle Harbor, or at 516-295-1410.

Remember when everything we knew to be true was always true? For most of us, that innocent time ended somewhere around our sixth birthday, perhaps with the discovery that the Tooth Fairy used our parents as agents instead of personally making the rounds of the world's pillows every night. But part of the human tendency to cling to happier times is a desire for things to remain constant once we have figured them out.

Take volatility, for example. Volatility is the term financial professionals use to describe upward and downward movement in the value of investments or "markets" (which, in this context, means a defined collection of potential investments, like the S&P 500 Index of stocks)- the larger the movement, and/or the more frequent the movements are, the higher the degree of volatility you have.

What We Absolutely Know About Volatility

For investors, it's long been an article of faith that volatility in a portfolio is a Bad Thing. It creates fluctuations in the value of our investments, it makes us uneasy about achieving our financial goals, it threatens our future happiness. Therefore, the less volatility we have in our portfolio, the better off we're going to be, right?

Not necessarily. Volatility is one of those things that can be good or bad. It all depends on the circumstances. It is important to understand just what volatility is and what it can do in a portfolio, because in the ongoing battle for financial security, that understanding can help you turn an enemy into an ally.

History Lesson

Look closely at a performance graph of the Standard & Poor's 500 Index, an unmanaged collection of 500 stocks of US companies that is widely accepted as fairly representative of the American stock market. Beginning in 1926 and coming forward to the present, the graph shows a series of connected line segments some up, some down. But if you step back and squint at the chart till the ups and downs blend into a solid line, that line goes steadily upward. The chart illustrates that volatility is always a factor in an investment plan, and that, while performance is never guaranteed, over long periods of time the broad market has always overcome downward volatility to trend upward.

What's Good About That?

Even though we understand that the long-term results of investing in the broad stock market have previously been positive, we may still frown on volatility because it makes us worry, and it has no intrinsically good characteristics. If it doesn't contribute to making my stocks more valuable, it's still a Bad Thing, right?

Not necessarily. It all depends on how you use it. Volatility is not just something that happens to your investments- if you react to it properly, you can make it work for you. A market downdraft creates one of those descending segments on the line chart we were discussing. While the market is down, investors should look carefully at their taxable portfolios, investments that aren't in pension, 401(k) or IRA accounts.

So, When is Volatility a Good Thing?

A volatile market can create opportunities to consolidate gains, harvest tax credits and generally reposition your portfolio while minimizing the tax consequences of all that activity. Indeed, there are professional money managers who specialize in using this approach, and some of them are so successful that they present their clients with positive total return and capital losses in the same portfolio. The capital losses can be offset against other investment gains, reducing overall tax liability.

Volatility can certainly be good for you if you have a taxable portfolio of securities that you've invested for the long haul, and if you know how to take advantage of the opportunities an active market provides. As I said, it all depends.

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