PrintOver the past three months, we have seen quite a bit of volatility. What we’ve been talking about the past week or so has been downward volatility—the drop following the Fed meeting and Ben Bernanke’s press conference. This is what most people mean when they talk about market risk, and what upsets people.
Understandably so. I would argue, though, that the run we had from November up until late May—an almost uninterrupted ascent of the market indices—was also an example of volatility that should have worried us even more.
Imagine if the situation had been reversed. Over a six-month period, the S&P 500 went up more than 20 percent. If it had gone down by 20 percent in an almost uninterrupted six-month descent, panic would have ensued. Think about the panic we had over a not-quite-6-percent decline from May to June.
The point I’m making here is that we tend to get upset over market declines, and think them abnormal, while accepting gains of the same magnitude as normal and expected. In fact, arguably, both should be considered in the same way, and our reaction makes it hard for us to rationally evaluate what we should do next—again, as we saw during the most recent pullback.
Why is this? There are a couple of psychological factors at play here. First, losses hurt more than gains feel good, so we overreact to losses. Second, we tend to accept good stuff as due to our own actions and deserved, while blaming bad stuff on forces outside our control. This is all well understood in the behavioral finance context.
But, although normal and understandable, it doesn’t actually work as a means of managing investments. It leads to selling at lows and buying at highs. The fact is, most investors do act this way, and if you look at the realized returns of investors—what they actually got—in most mutual funds, you find that they are much lower than that of the fund itself. People bought in high and sold low, and therefore made less (or lost more) than they would have if they had simply bought and held.
Volatile funds showed this effect more than less volatile funds, which means that, for the average investor, volatility itself can lead to poorer returns. Think about that—as the market gets more volatile, it can drive you to do things that will cost you money.
This brings us back to my initial point, that volatility includes both upside and downside action. Just as you may be driven to sell when the market declines—at exactly the wrong time—you may also be driven to buy when the market has run up, also at exactly the wrong time. Volatility either way can make you do something you may later regret.
This is relevant not only because of the recent pullback but also the sharp recovery over the past couple of days, as well as the large gains since November. A small pullback didn’t mean a crash was imminent, and the recovery over the past couple of days doesn’t mean the climb resumes.
I take two points away from this discussion. The first is that you should put some thought into the framework you use for making your investment decisions. You should know what you’re looking at and why. The second is that you need discipline in applying your decisions.
This doesn’t guarantee success, of course, but it does prevent the sort of knee-jerk behavior that more or less guarantees failure, and preventing certain failure is a big part of eventual success.
