As I was running on my treadmill one early August morning watching the opening bell on the Bloomberg stock market channel, the Dow Jones Industrial Average was down 200 points in the first seven minutes. The day before, the Dow was up over 150 points. It certainly seems like the stock market is more volatile lately. If so, what should we be doing about it?
The reasons for the daily market volatility vary. Recently, much of the volatility has been due to liquidity concerns related to the sub-prime mortgage problems. But the next big movement up or down may be caused by some other concern or source of elation. We’re also seeing huge amounts of cash moving in and out of the markets on very short notice. This type of rapid trading activity is done by “speculators,” not long-term “investors.” In an attempt to gain an advantage, some large hedge funds are placing huge bets on the short term direction of the market (often with borrowed funds). If you are a long-term investor putting aside money for your retirement, do you really care what the market does in the next 25 minutes?
The markets may appear to be more volatile on a daily basis, but if we look at monthly history, the relative volatility has actually been dropping. Take a look at the chart on page 2 showing the returns and volatility (as measured by “standard deviation”) of the Standard & Poor’s 500 Index over the last few decades.
Note that US stock returns in the first decade of the 21st century to date have been disappointing — largely due to the three year market drop from 2000-2002. At the same time, the standard deviations of the monthly returns have also been lower than they were in the 80’s or 90’s. International stocks show a similar pattern over the same period— return volatility has been declining over the last three decades. One factor that makes volatility seem so high these days is simply the fact that with the market levels so much higher today, a 2% swing in market value involves a much larger jump than it did when the market levels were much lower.
Volatility is a natural part of investing. Historically, both the US and International stock markets have gone up about 2/3rds of the time. Trying to “time” when to sell and when to buy back typically proves treacherous. Much of the market’s return occurs in large movements — often unexpectedly. You can easily miss large returns (permanently) if you have exited the market and are sitting in cash when that move occurs.
Interestingly, market volatility actually creates some investment opportunities. We “rebalance” your portfolio when one of two things happen:
1) When one part of the market is doing much better or worse than the rest of your portfolio, we have an opportunity to sell the better performing asset class and buy the lesser performer. While this seems counter-intuitive, studies have shown that rebalancing in this way significantly improves returns.
2) You can also take advantage of market volatility by adding to your portfolio on a recurring basis. This allows us to maintain your target allocation by using your new cash to buy whichever part of your portfolio is “on sale.”
The bottom line: try to ignore the day-to-day movements in the stock markets. Remember that you are an investor and not a speculator. If hedge funds want to try to time the market, let them— stay focused on your long term goals instead. Watching the daily movements of the markets only serves to raise your blood pressure and move your attention away from what is important.
By David Cowles, Director of Investments