The Investment Scientist

Market Volatility, Emotions, and Investment Risk

Posted on: September 7, 2011

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:

  1. 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.
  2. 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.
  3. 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.

2 Responses to "Market Volatility, Emotions, and Investment Risk"

I am not an educated fund manager or financial planner. I have and still use a financial planner for a portion of my holdings. What I have discovered in the last 3 years is that a “disciplined investor” rides out the storms. Or, in other words, we’ll be OK in the next rising tide.

Some of my assets are in local rental properties. I buy the ugliest house in the neighborhood, fix it up, update it to modern living standards and rent it for a competative price. I can do this for two reasons. 1. area landlords are maximizing their investment. and 2, I’m buying at the bottom of the market. Therefore, my margin is better than the guy that got in earlier. Sounds like a bargain and that’s what it is.

For stocks, I have to have a bargain, it has to be something I notice people are attracted to, and also an exit strategy. If I have those things and put a trailing stop in for the -500 pt days, even in the ups and downs of today’s market, I can beat the street without a margin account or being glued to the “instant trader’s screen”.

In general I think people are looking for the one thing that will solve all of their problems. Generally speaking, it’s not out there. A good financial planner can do that. In a changing world I cannot continue to do the same thing time after time and expect a consistant result. A good financial planner will be aware of changes before too much damage occurs. In short, playing defense may be at least as important as picking the right things.

A company has to sell goods or services to create revenue. What people desire (the things they buy) constantly changes. It changes from age, from patriotism, from politics, from economic times, from what the neighbors do…it is a constant change machine. To buy and hold a stock for 20 years may or may not be a good choice. It depends whether it’s Apple or GM.

Two and a half years ago around the holidays I went into a sporting goods retailer in Phoenix, AZ. I noticed the counter at the gun room had 50-60 people waiting in line to purchase guns. This was curious to me since I had never owned a gun. When I returned home I purchased some stock in the retail chain, and I also looked for a domestic gun maker that had the ability to gain from the market. Both of the were very good choices at the time. The gun maker is now 3 times the value of when I purchased. Will I hold it forever? Probably not. Because their customer’s desire to purchase guns may change. And, after they have built their physical plant, inventory, supply lines, and payroll to match today’s demand, they will have to make gross adjustments if/when the trend changes.

Every business faces that.

If all of your retirement is in a single investment vehicle, if it’s not important enough to learn something about, if it’s too inconvenient to manage some of it yourself or find the right person for you…then the results will be subject to all the pitfalls of institutional investing. I look at it like this. Would I give $1000 to your best friend, telling him take care of this for me…I’ll pick it up in 20 years? If I couldn’t do that why would I leave a couple hundred thousand dollars in the TSP, or some other corporate 401K?

Ron,

Your investment approach is very interest. It is value oriented and it is Peter Lynch like.

I have a friend who bought AAPL three years ago when he saw his children spent their meager incomes on iPhones. I have another friend who work at a college placement office. She would buy stocks based how how many students they want to hire. These keen observers actually bring useful information to the market, and they deserve the extra returns. They are quite unlike the trading bots that account of 80% of the volume in the market now.

Michael

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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