The Emotionally Stable Outlook

Nov 2014 //
Risk vs. Volitility
Behavioral Finance

…the Dow Industrials gained 347.62 points for the month of October [2014], which represents a 2.04% return, not counting dividends.  On a daily basis, this worked out to an average gain of approximately 15.11 points.  If that was how October actually played out—a gain of 15.11 points per day—most investors would have been calm and happy.  However, as you can see, the actual daily results in October were anything but uniform.  There was a sharp 334.97 drop one day, followed by an additional 338.18 point drop over the next two days.  That scared a number of investors, as sharp drops always do.  However, there was also a net 1,273.28 point gain over an 11-day period later in the month.  (These sharp up and down movements are not exactly supportive of the theory that market prices are “efficiently” determined.)   With these results as background, we have two questions:  (1) For everyone other than those with exceedingly short time horizons, what difference did it make that stock prices were volatile during the month?  (2) More generally, given the strong returns historically earned by diversified portfolios of stocks over the long term, what difference does it make that stocks can be volatile over months, quarters or even years?  As long as an investor has income from dividends (and/or other sources) and a sufficient buffer to preclude forced investment sales for living expenses, short-term volatility amounts to just one thing for the intelligent and emotionally stable investor—an opportunity to buy low.  (Remember, in order to reduce the risk of forced sales, we maintain appropriately-sized cash/money fund buffers within client portfolios to address known withdrawal needs.)  This is easy to say, but it’s not easy for many investors to accept.  Indeed, there will always be those who develop overwhelming fears in response to stock market dips.  Despite 100+ years of evidence to the contrary, these investors tend to see Armageddon behind news headlines and under every rock.  Though these people are entitled to their own views, whether they have a basis in fact or not, it is important to recognize that there is a price to be paid for unwarranted pessimism.