Investor Fear Feeds Volatility

We read a thoughtful analysis about recent stock market volatility that helps explain why, although the market may be reacting to some recent news or event, we most often recommend that clients remain invested without making changes to their investments.

This article from American Century Investments examines the volatility of the S&P 500 Index in the short term through the activity in October and November of this year, as well as over longer periods. Over the past two months, 27 of the 42 trading days recorded daily index price swings of at least +1% or -1%, while 12 of the 42 days had swings of at least +2% or -2%. Yet at the end of the 2 months the S&P 500 Index had a positive gain of over 10%. An investor who held on and ignored the volatility earned a nice reward.

Over a longer time frame the study indicates that daily market volatility goes through periods when it is elevated and periods when it is lower than on average. It exhibits a “mean reverting” property; i.e. when volatility is higher than its long term average there will more likely be a decline in volatility than an increase in volatility over some future time period.

Short-term volatility is simply a reflection of investor uncertainty. For example the S&P 500 Index declined -20.47% on Monday October 19, 1987, known as “Black Monday.” This was the largest single-day decline in the index since 1950. Yet the next 2 days the index was up 14.92%. The earnings of the companies within the index could not possibly have changed in a mere 3 days, so fundamentals do not explain the huge swing. Fear and greed, more than the value of the stocks, is often cited as the force behind these fluctuations.

Myriad global and economic issues certainly contribute to unrest in the market. The general culprits include the European debt crisis, the US deficit, political uncertainty, slow economic growth and weak employment. When investors feel uncertain they tend to react more quickly to news, thus increasing market volatility. Because their behaviors are not always grounded in sound financial analysis, an eventual inverse reaction is likely to follow. While we have seen market volatility increase of late (as well as trending up over the long-term), it does not preclude the possibility of earning positive returns. This is why we frequently advise clients not to make portfolio changes based on daily or short-term news. We may sound like a broken record but there is good reason to stay level-headed when things look dire. We can’t get rid of the fear and greed that drives much of the market fluctuations, but we can react wisely. As the great investor Warren Buffett says: “Be fearful when others are greedy and greedy when others are fearful.” ~Jill