Broker Check

Is Market Volatility Friend or Foe?

January 14, 2020

December 2018 represented the worst December in the stock market since 1931. This was certainly an unwelcome surprise for investors. This development may seem especially extreme after the unusual calm we’ve had in the markets during most of 2017 and 2018. In those two years, the measure of volatility, called the “VIX”, remained at historically low levels for extended periods of time- almost half the long-term average. In fact, the lowest level of volatility ever measured was November 3, 2017, at just 9.14. You’d be forgiven if you didn’t notice that particular milestone since it was simply a very “calm” day in the markets. Today, our volatility is right around the long-term average of 19.4, yet the talk everywhere is how everything is going “off the rails”. Why is this?

Well, first it’s because there appears to be an inverse relationship between the level of the S&P 500 and the level of volatility- at least over the short run. As volatility goes up, the stock market tends to go down. The interesting thing, however, is that volatility, as measured by the VIX, appears to make much bigger swings than the stock market itself. In other words, the market’s movements up and down on a daily or weekly basis, appear to be much more extreme than if you were to simply graph the overall change in the value of the markets over time.

There are several factors responsible for this. One is the tendency to focus on short-term versus long term market performance. Anyone who dissects the chart of the S&P 500 index over time can easily spot a long-term upward trend line even though a closer examination will reveal significant volatility on an annual basis within that trend. Unfortunately, we plan on the basis of the long-term trends while we live as emotional beings within the short-term daily trials that life hands us. That is why it is so hard to “stay the course” when every emotional fiber within us says “run”!

The second factor is the human tendency to notice pain of loss more than the joy of gain. This has been confirmed by multiple experiments showing people become increasingly “loss” averse after they believe they have received a certain gain. We pay attention when markets become volatile and start falling- especially after a sustained period of historically low volatility and market gains, precisely because we hate losing what we think we gained- even if we know that volatility is part of investing and the “loss” on any particular day is no more certain than the gain we thought we had just prior.

The last factor is perception bias. We judge the world mostly from our recent experiences- even if those experiences are historically abnormal. When 30-year mortgage interest rates changed from 3.00% to 4.5%, we feel that the new rate environment is “not right”, even though it is far closer to the long-term average 30-year rate and the 3% rate represented a historically low aberration. The same is true of stock market volatility. Today, with market volatility back to its average level of the past 30 years, we may feel things have become “much worse” when in fact we are simply experiencing a perception bias based on recent events.

So, the next time you hear talk about how “volatile” the markets have become, remember that nothing lasts forever, think about your long-term plans and, do a reality check to see if what appears to be happening is simply distorted by recent events. In many cases you may be well advised to just “fuhgeddaboudit”!