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Warren Buffett: Do Not Fear Volatility

We recently looked at Warren Buffett (Trades, Portfolio)'s 2014 letter to shareholders of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), in which he explained why stocks are a less risky asset class than bonds. This may seem like a counterintuitive position to take, given that bonds generate a steady, predictable stream of income while some stocks don't even pay a dividend.

But Buffett's logic was based on the steady depreciation of the U.S. dollar, which he believes has eroded the value of income-bearing assets like U.S. Treasuries. Stocks are more volatile than bonds, but less risky. Here's why Buffett believes that short-term fluctuations in the price of equities have no bearing on their intrinsic value.

Volatility is not risk

Buffett is quick to point out that owning stocks may not be the best choice for investors who have a short-term need for cash, or for investment banks that will be threatened if the value of their balance sheet declines. Most people, who don't fall into these categories, would be better served by investing with the long-term view in mind:

"For the great majority of investors, however, who can - and should - invest with a multidecade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities."

What's more, the drive to avoid volatility can actually lead investors to take riskier actions than they otherwise would. By putting their capital into securities like Treasuries or other bonds, they are paying the opportunity cost of not being able to reap the benefits of compound interest. By investing in a basket of stocks whose dividends can be constantly reinvested, they can create a good retirement pot:

"Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in 'safe' Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure)."

There are many things that investors can do to make stock ownership more dangerous and uncertain than it needs to be. By trying to time the market, or holding stocks for short periods of time and trading in and out of positions, investors can burden themselves with unnecessary fees and miss out on periods when stocks are performing well. No one can predict the near-term future, but you can hitch your wagon to the American economy for the long run. It seems to have worked for Buffett.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.