Why The Stock Market Is Volatile, Why Volatility Hurts, And What To Do About It

Originally in ForbesUnless you made a resolution not to read, listen to or watch the news in 2016, you’ve likely noticed that “the market” is off to a stumbling start. Indeed, one glance at the headlines, at least the ones that don’t involve the presidential election, quickly reveals that the market is having one of its worst starts to any new year. This is a dubious distinction, to be sure.

The factors involved appear similar to those credited for causing the extreme volatility we saw in the fall of 2015—slower growth in China, falling oil prices, geopolitical instability and the threat of bankruptcies in junk bonds. But the optimist’s case seems equally compelling—high-quality bonds (the only kind I recommend) are performing very well, falling oil prices are good for consumers, the Fed’s interest rate rise signals a strengthening U.S. economy and the most recent jobs report was positive.

An objective view of the market reminds us that on every trading day in history, there have been compelling cases to be made for both optimism and pessimism—for purchases or sales. (Remember that every single security transaction involves a buyer and a seller, each of whom believes he or she is getting the better end of the deal.)

Ultimately, there is only one sufficient answer to the question, “Why is the market so volatile?” The market exhibits volatility because that is its nature.

We expect to make more investing in bonds than in cash because bonds are more risky. We expect to make more investing in stocks than in bonds precisely because they force us to endure even more uncertainty, and this logic continues to extend through the various slices of the market we isolate for the purposes of diversification (like small and undervalued companies).

But most importantly, the willingness to endure volatility has tended to reward the disciplined investor, and often the greatest reward immediately follows the most significant times of market turmoil. The greatest folly, then, is in attempting to divine precisely when these times of volatility will begin and end. Whether motivated by fear or pride, it is the business of prognostication that hurts investors most.

Does this mean that inaction is the only course of action in these times? Certainly not. Losses can be harvested in taxable accounts and replaced with similar securities, an activity that may benefit you at tax time. And in all your accounts, you have the opportunity to follow Warren Buffett’s chief investment advice—to buy when other investors are fearful—through strategic rebalancing. Doing so positions you to make the very most of the next market move upward.

I recently saw Jim Cramer, perhaps the face of market prognostication, confess, “I need a little perspective. We’re a little caught up here in the short term.” There is a reason that Mr. Cramer—and at times, you and I—get stuck in the short term. And it can be explained by behavioral science. We innately over-value losses and pain while under-weighting gains and joy, in money and life (explained in part by the “endowment effect”). And at the same time, we also over-weight what has happened most recently while under-valuing the more likely, long-term outcome (known as “recency bias”). Therefore, as you can imagine, recent losses are a powerful psychological duo that can even lead to clinical depression (a topic that my colleague, Larry Swedroe, recently wrote on).

The fundamental truth, and what I believe to be the antidote for this downward spiraling, is that we don’t invest in our portfolios for today, this month or even this year—but for decades in the future. Therefore, the unavoidable intermittent downside, like that which we’ve experienced in the first weeks of 2016, does not result in losses, per se, but merely declines.

This does not suggest, of course, that you must have a portfolio invested solely in large U.S. companies and then hold on with a white-knuckle grip while the market joyrides. Virtually every portfolio should include conservative fixed income and any equity exposure should be well diversified. And because human nature causes us to suffer market losses more deeply than we enjoy market gains, it’s prudent to err on the side of conservatism in portfolio construction. Furthermore, we should not be blinded by recency bias, either through over-optimism in good times or unfounded pessimism in bad times.

But once we have completed the process of portfolio construction, appropriately balanced in accordance with our ability and willingness to endure risk, it is imperative that we maintain discipline in volatile times. Indeed, the only way the market rewards us is if we’re willing to tolerate its eccentricities.

If You Don’t Like The Market Today, Just Wait Until Tomorrow

Originally in ForbesIn my hometown of Baltimore, there’s an oft-heard saying that seems especially applicable when, like now, the seasons are changing: “If you don’t like the weather today, just wait until tomorrow.” For whatever meteorological reason, it’s not uncommon for an absolutely miserable Monday to turn into a gorgeous Tuesday. Temperatures have been known to swing as much as 20 degrees inside of an afternoon.

A scientific view of stock market history, unfortunately, shows us an even greater propensity for unpredictability and volatility.

Even the years that we refer to as the “good” ones, in retrospect, test our mettle. For example, between 1950 and 2014, a span of 65 years, the S&P 500 ended the year with a gain 51 times (or in almost 80% of them). Not bad. But in how many of those up years do you think investors would’ve found themselves in a “losing” position at some point in the year?

Every. Single. One. 

The Market Volatility Survival Tool: True Grit

Originally in ForbesIs recent stock market volatility bugging you?

True Grit

Do you wince with every headline announcing Greece’s demise, China’s bubble(s), the Federal Reserve’s indecision or the Dow’s down day?

Do you sneak a peak at your portfolio’s performance more than quarterly (or perhaps even annually)?

Does market volatility tempt you to question your investment strategy, even if it’s well thought out and carefully implemented?

Does it weaken your resolve to resist the sky-is-falling siren song heard so frequently in the financial media, or the sales pitch du jour?

Having the right investment strategy is important—really important—and surely contributes to long-term success in building wealth. But no matter how superlative your strategy, it’s your willingness to stick with it that ultimately will help you meet your financial goals.

What the #@$% is going on?

Unless you live under a rock (check out this Geico commercial referencing under-rock living if you haven’t seen it), you have picked up the message that volatile markets and bumbling economies have again captured the global consciousness.  If you looked at the headlines any of the last several days, you may very well have concluded that the sky is falling and the financial crisis of 2008 is returning.  A great article in the Wall Street Journal explained “Why This Crisis Differs From the 2008 Version,” but that still leaves us with the nagging question, “What the #@$% IS going on?”  (I’m not promoting profanity, only acknowledging that times like these have a tendency to inspire it.)

Strangely, the majority of the talking heads on television render their contrary opinions on what’s going to happen in the future—tomorrow, next week or next month—spending very little time educating us on what the underlying reasons are for our current crisis.  In the spirit of the Freakonomics team, who, in a recent podcast demonstrated “Why we are so bad at predicting the future,” I’ll avoid attempts at prognostication and seek instead to explain what IS and what ISN’T going on in the global economy at present, followed by a couple suggested action steps:

Debt ceiling?  S&P downgrade?

The big news of the last few weeks has been debate over the debt ceiling and the seemingly corresponding S&P downgrade of the United States government.  The market has been expecting this downgrade, regardless of what happened with the debt ceiling, for quite some time now—it wasn’t a surprise.  Besides, S&P’s ineptitude regarding the accuracy of their ratings, most notably demonstrated by their maintenance of top ratings on the junk that helped cause our financial collapse in 2008, has justifiably rendered their guidance nearly impotent.  It was suggested that if the debt ceiling was not raised, the U.S. would not be able to pay its bills for the first time in history and that could lead to a financial collapse.  Well, the debt ceiling WAS lifted, but the market responded by crashing.  How do we explain that?  The problem we’re experiencing now has little to do with the debt ceiling, but a lot to do with debt, in general.

So what is happening?

The U.S. certainly has its own debt problems to contend with, but while the U.S. media got narcissistically wrapped up in our own debt ceiling and S&P downgrade, it obscured the more imminent problem—major European countries threatening default.  We’ve all heard about the financial troubles of Greece, Ireland and Iceland—each of which required financial assistance to stay afloat—but following those three countries are Italy and Spain.  They’re much bigger economies, and their failure may not be sustained by the European Union (EU) and the International Monetary Fund (IMF).  And just within the last couple days, one of the stronger European countries’ banks, France, is sending warning signs pointing to another potential crisis there.

Deja vu?  (Not really)

In the Great Depression, we basically allowed the natural free-market system to run its course.  That resulted in the pain of 25% unemployment and a stock market decline of over 90%. The silver lining, however, was that after the economy recovered from its sickness, we got back on the path towards financial health and prosperity.  This time around, the government took unprecedented action to keep us from experiencing Depression-like immediate pain, but many suggest they just deferred the problem and that we’ll be dealing with it for many years into the future.

So the United States and other countries around the world started “printing money” to create growth in their economies, in the hope that increased money supply would pull us out of a recession headed towards depression.  But while it can’t (yet) be said that the U.S. is again dipping back into a recession (the dreaded “double dip”), some major European countries are headed quickly in that direction, and that contagion could spread around the world.  Again.  Governments have already started responded with measures similar to those utilized in the 2008/2009 financial crisis; doing whatever they can to create monetary liquidity they hope will spur growth.  This could result in a boost for economies and markets in the coming weeks and months, but it’s certainly no guarantee.

So, what can you do?

You shouldn’t make wholesale buying or selling decisions in your investments based on what a market does in a day or a week, but this current calamity should prompt you to return to your portfolio and take a long, hard look at what you own and why.  Whether you are a strict buy-and-hold asset allocator or an active investor, your strategy must recognize and contend with the possibility of times like these.  You—and your financial advisor—must be accountable to articulate why you own what you own and how you intend to react depending on further developments in this scary story.  I’m not recommending you buy, sell or “stay the course;” I’m recommending you educate yourself and then act accordingly, not out of impulse.  There is no bliss in ignorance.

*This post will also be featured on TheStreet.com.