Volatility: The Silver Lining Playbook – Part 4
This week I will share the last three of the top ten reasons I believe we need to reframe our view on volatility, A.K.A., my “volatility silver lining playbook.”
And the final three are…
Volatility is a reality check for venture capitalists
Ever wonder where those ridiculous IPO share prices come from? Venture capitalists. Market volatility is a great way to keep them in check when valuing startups and potential IPOs. Sometimes, despite the absence of profitability and a high debt load, high-growth companies get overvalued.
The are several problems with this, and perhaps the most problematic is that with growth companies, there is a large margin for error when markets are climbing. What if lending markets tighten when the IPO comes out? These companies need a lot of money to grow their businesses, making borrowing money hard for them. All that combined with overvaluation does not make for a healthy beginning for a startup. Volatility should give venture capitalists pause as they decide the value of start-up companies that don’t have much history.
Volatility encourages active investment
Exchange-traded funds or ETFs have exploded in the last ten years. This rise has been driven in part by the growth we have seen in the markets, making investors believe they don’t need to be selective when buying stocks to get good returns. However, passively managed funds can’t change their holdings when things get rough in the markets. In fact, in 2018, a standard passive fund that mirrors the S&P 500 was down -9% for the year. Year-end volatility can be an excellent reason to seriously consider if passive investments are the right place to be depending on an investor’s risk tolerance and investment horizon.
And last, but not least…
Volatility facilitates functional capitalism
It’s pretty simple, folks, the “invisible hand” of the market is driven by fear that gets stirred up by volatility and fed by the media. We’re all afraid to lose money, and that’s a good thing; in fact, it’s as normal as volatility!
Without fear of loss, too much money would flood into high-risk investments, creating dysfunctional capital because companies would be overleveraged and overexposed. And we all know what that leads to… “government bailouts,” “too big to fail,” and all those PTSD-inducing terms. Investors begin to lose faith in the system and pull their money out, keeping it in cash to be safe. Investment capital is significant to a company’s growth, and it is the fuel that a free market economy needs to grow at a comfortable rate.
Now that we’ve talked about many reasons that volatility is indeed a good and needed thing for the markets, I want you to keep these ideas in mind as we continue to recover from the financial uncertainty the pandemic brought. Next week, I will wrap up this series with a recap of my “volatility silver lining playlist” that you can use to still your nerves when needed.
P.S. If you enjoyed what you've read here and found it beneficial, we encourage you to share it with your friends and family. I firmly believe that an educated investor is more confident, which leads to healthier finances and fewer sleepless nights.
Until next time...
1 10 Reasons Volatility Is Good for the Stock Market