Why The Stock Market Is Volatile, Why Volatility Hurts, And What To Do About It
Unless you made a resolution not to read, listen to or watch the news in 2016, you’ve likely noticed that “the market” is off to a stumbling start. Indeed, one glance at the headlines, at least the ones that don’t involve the presidential election, quickly reveals that the market is having one of its worst starts to any new year. This is a dubious distinction, to be sure.
The factors involved appear similar to those credited for causing the extreme volatility we saw in the fall of 2015—slower growth in China, falling oil prices, geopolitical instability and the threat of bankruptcies in junk bonds. But the optimist’s case seems equally compelling—high-quality bonds (the only kind I recommend) are performing very well, falling oil prices are good for consumers, the Fed’s interest rate rise signals a strengthening U.S. economy and the most recent jobs report was positive.
An objective view of the market reminds us that on every trading day in history, there have been compelling cases to be made for both optimism and pessimism—for purchases or sales. (Remember that every single security transaction involves a buyer and a seller, each of whom believes he or she is getting the better end of the deal.)
Ultimately, there is only one sufficient answer to the question, “Why is the market so volatile?” The market exhibits volatility because that is its nature.
We expect to make more investing in bonds than in cash because bonds are more risky. We expect to make more investing in stocks than in bonds precisely because they force us to endure even more uncertainty, and this logic continues to extend through the various slices of the market we isolate for the purposes of diversification (like small and undervalued companies).
But most importantly, the willingness to endure volatility has tended to reward the disciplined investor, and often the greatest reward immediately follows the most significant times of market turmoil. The greatest folly, then, is in attempting to divine precisely when these times of volatility will begin and end. Whether motivated by fear or pride, it is the business of prognostication that hurts investors most.
Does this mean that inaction is the only course of action in these times? Certainly not. Losses can be harvested in taxable accounts and replaced with similar securities, an activity that may benefit you at tax time. And in all your accounts, you have the opportunity to follow Warren Buffett’s chief investment advice—to buy when other investors are fearful—through strategic rebalancing. Doing so positions you to make the very most of the next market move upward.
I recently saw Jim Cramer, perhaps the face of market prognostication, confess, “I need a little perspective. We’re a little caught up here in the short term.” There is a reason that Mr. Cramer—and at times, you and I—get stuck in the short term. And it can be explained by behavioral science. We innately over-value losses and pain while under-weighting gains and joy, in money and life (explained in part by the “endowment effect”). And at the same time, we also over-weight what has happened most recently while under-valuing the more likely, long-term outcome (known as “recency bias”). Therefore, as you can imagine, recent losses are a powerful psychological duo that can even lead to clinical depression (a topic that my colleague, Larry Swedroe, recently wrote on).
The fundamental truth, and what I believe to be the antidote for this downward spiraling, is that we don’t invest in our portfolios for today, this month or even this year—but for decades in the future. Therefore, the unavoidable intermittent downside, like that which we’ve experienced in the first weeks of 2016, does not result in losses, per se, but merely declines.
This does not suggest, of course, that you must have a portfolio invested solely in large U.S. companies and then hold on with a white-knuckle grip while the market joyrides. Virtually every portfolio should include conservative fixed income and any equity exposure should be well diversified. And because human nature causes us to suffer market losses more deeply than we enjoy market gains, it’s prudent to err on the side of conservatism in portfolio construction. Furthermore, we should not be blinded by recency bias, either through over-optimism in good times or unfounded pessimism in bad times.
But once we have completed the process of portfolio construction, appropriately balanced in accordance with our ability and willingness to endure risk, it is imperative that we maintain discipline in volatile times. Indeed, the only way the market rewards us is if we’re willing to tolerate its eccentricities.