Markets Give and Take; A Primer on volatility

July 09, 2021

What Is Volatility?

Volatility is defined as the range of possible returns for a given security or market index over a given period; this range can include upward or downward movements.  The uncertainty of future events (i.e. interest rate movements, economic growth) can change periodically, sometimes resulting in dramatic changes in volatility.

When Do We Notice Volatility?

We tend to notice volatility when the news brings it to our attention, often after a downdraft in the market caused by a reaction to a big news story.  A popular measure of volatility is the stock symbol VIX, the stock market's expectation of volatility and the popular name for the Chicago Board Options Exchange's CBOE Volatility Index, which is based on S&P 500 index options.  If short-term volatility continues in a downward direction for several weeks or months, we often have a correction or a bear market.  During the 2008 financial crisis and the Great Recession, the S&P 500 fell 57.7% in the six-month period from October 2007 to March 2009. In 2020, the coronavirus pandemic sent the world into a recession and equity markets reeling as the S&P 500 plummeted 51%.

Why Is Volatility Important?

We would like to believe that the stock markets are primarily controlled by level-headed professional investors; however, individual investors, and sometimes professionals, act irrationally, not always making decisions based on fundamentals. It is too easy for investors to be influenced by coworkers, news, and IPOs; if stock market volatility is perceived as being higher, the result is that stock market investing seems scarier.

It is often said that “the pain of losing is twice the pleasure of gaining”; this quote summarizes the concept of loss aversion, where investors are irrationally more afraid of possible loss in the stock market, at any given point, than an equally likely gain.  This fear often prevents investors from making rational decisions, such as “buying on a dip”, or continuing to “stay on the sidelines”.

Some investors are unaware of the percentage increase that is required to “dig yourself out of a hole” once the stock market has gone down significantly.  For example, if the stock market were to fall by 20%, it must then go up by 25% to return to the same place (e.g. $100 to $80 to $100).  In an extreme example, if the stock market were to go down by 33%, it must then go up by 50% from its new starting point to return to the same place ($100 to $66.66 to $100).  Often the downward movement is quick, over a few weeks or months, whereas the recovery period is typically much longer, in many cases taking several years. 

Despite memorable recent downturns (e.g. dot-com bubble, housing crisis, Covid-19 pandemic), stocks have averaged a healthy ten percent (10%) return over the last 30 years.

What Can We Do About It?

Dollar Cost Average 

When volatility rises, and the market’s direction is uncertain (often the case), a newly funded account can be invested using Dollar Cost Averaging, whereby the cash to be invested is broken into several same-sized amounts, or tranches, and invested at regular intervals over several weeks or months.  This technique increases the odds of buying on a mixture of both relatively high and low-price levels, and may result in a more acceptable “entry point”.  Remember, no one has a crystal ball to aid in timing the market and buying (or selling) at the optimal moment. 

Avoid Hot/Cold Strategies

When selecting an investment strategy, it is sensible to avoid strategies that perform in either the top 25% of peers, or the bottom 25% of this same group (hot/cold).  Most investors would prefer strategies that are consistently above average over the long run, not ones that make them feel “whipsawed”.

Upside / Downside Participation

As part of the strategy selection process, it is tempting to only focus on Upside Participation, the degree to which a strategy’s price movements keep pace with an index’s upward movements.  Be leery of strategies with significant Downside Participation, as their prices often suffer more than the overall stock market during a market downturn. This can be magnified by concentrated positions or investments that use leverage.

Focus on the Big Picture

When trying to overcome loss aversion, investors should not focus on each individual strategy or investment; instead, they should think about the overall net impact of the portfolio over time. As one of our most admired academics and investors, Nobel Laureate Eugene Fama stated “ to me about 10 years and you’re starting to talk about a relevant investing time frame.” Short-term volatility often masks the true long-term wealth building effects of sticking to a well-designed investment plan. Maintaining a focus on long-term return expectations associated with Financial Planning should help steer you on a clear path towards achieving your financial goals.