Understanding Volatility

Sarah F. Roach

When markets become volatile, as they have recently, investors may feel heightened emotions kicking in. When prices move sharply higher, many people, to their detriment, eagerly buy popular stocks (at inflated prices) so as not to miss the boat. In contrast, when prices plummet, anxiety pushes some to exit “before it’s too late” —regardless of an investment’s objective merit. In his new book, Mastering the Market Cycle, famed investor Howard Marks devotes an entire chapter to this psychological pendulum. He emphasizes the impact emotional excesses have on the magnitude of market cycles, saying “…I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.” Underscoring this point, he adds that “…in the real world, things generally fluctuate between ‘pretty good’ and ‘not so hot.’ But in the world of investing, perception often swings from ‘flawless’ to ‘hopeless.’”

Successful investors retain their objectivity and emotional equilibrium despite market volatility. A disposition toward lower emotionalism helps, of course, but experience and an understanding of history are even more important. For example, consider the 47-year period between 1970 and 2016, which included individual years of both +37% and -37% returns, and an average annual return of 10%. Marks determined how many of those years the S&P 500 produced returns within two percentage points of its 10% average, and you might be surprised to learn that it occurred in only three of those 47 years. Moreover, there were 13 years that ended 20 percentage points away from average—either up at least 30% or down at least 10%! Large price swings don’t frighten investors who are aware of how common they are.

As we’ve written in the past, markets gain momentum— in both directions—on extreme investor emotions. It is often said that people are driven by greed or fear (or call it euphoria/depression, optimism/pessimism, etc.)—and markets are driven by people. A primary goal of intelligent investing is to put a value on the future, and you’re not going to do that well if your view of the future is influenced more by emotional extremes than analytical objectivity. To quote Marks again, “This cycle in investors’ willingness to value the future is one of the most powerful cycles that exists.”

Our job is to analyze investment opportunities objectively—using the breadth of our experience and knowledge. In addition, we educate clients by regularly sharing our interpretation of the investing and economic environments, as well as our take on the emotional climate. Through education, we hope we can help clients minimize the influence of emotional extremes on their decision-making. To that end, we’ve written an article about considering volatility when planning your account withdrawals. Our website article, “The Hidden Trap of Average Annual Returns and The Adaptive 5% Solution,” contains recommen­dations that incorporate volatility into withdrawal planning, since swings in investment performance are inevitable. Remember: Annual returns that aren’t average also aren’t uncommon.