Market Volatility, Emotions, and Investment Risk
Posted September 7, 2011on:
Imagine your house has a ticker symbol, and it scrolls along the bottom of CNBC together with other ticker symbols. The price of your house, like a stock price, is set by a bunch of people you’ve never met making apparently random bets based on a combination of intuition, general economic statistics, output of an automatic-trading program, and, a couple of times a year, the real price achieved by one of your neighbors actually selling a house.
Minute by minute, the price of your home would gyrate wildly. If you are a nervous type, you might lie awake at night wondering if its value would cover your mortgage in the morning.
Welcome to the world of asset price volatility. Luckily, the above scenario does not happen to your house, it just happens to your stocks.
Early last month, when the market fell by 15% in a week, I had a few nervous clients calling me to ask if we should get out of the market outright. (I also had a few very smart clients who added money to their accounts.)
Here is what I told them. Imagine your portfolio represents a share of the world’s business, selling goods and services to all people in the world. As long as the people are there, they will continue to buy the goods and services that this business provides. (I diversify client portfolios across all continents, all industries, and all capitalizations using asset class funds, so that’s not a far-fetched analogy.) If the share price of the business falls by 15% in a week, that’s a great buying opportunity. Is it not? Would you sell your house if its price dropped by 15% in a week?
I am glad they listened to me, by the end of the month, the market had recovered two-thirds of the 15% fall.
Robert Shiller, author of Irrational Exuberance, found that stock price volatility is 13 times (discounted) dividend volatility. Think about it, the price is what we pay for the dividends. If the dividends are not volatile, why should the price be very volatile? There are three reasons:
- While economists say stocks prices should be determined only by expected dividend streams. In reality, stock prices are also driven by human emotions. And human emotions are very volatile.
- 80% of the trades in the market are done by trading bots now. These bots take a blip in the market and generate a bunch of trades. They amplify the volatility.
- Larry Summers, Harvard professor and former Treasury secretary under Clinton, postulates in one of his research papers that smart money (Wall Street banks, hedge funds) could intentionally creates excessive volatility to take advantage of naive investors who buy on greed and sell on fear.
The risk of market volatility is allowing yourself to become emotional and being taken advantage of.