March 2018 Comments: The Volatility of Stock Prices

Victor Levinson Comments

There have been many days during the first quarter when stocks have fluctuated, either up or down, more than one percent. Some days, those fluctuations have exceeded two percent. The investment community and media refers to these kinds of large fluctuations as volatility.

We can use the major US stock indexes as illustrations:

  • With the Dow Industrials at approximately 24,000, a 240 point price change is one percent, and a 480 point price change is two percent.
  • With the S&P 500 at approximately 2,600, a 26 point change is one percent and a 52 point change is two percent.
  • And for the NASDAQ Composite at 7,000, the figures are 70 and 140 points, respectively.

During the fourth quarter of 2017, a period of almost no volatility, there was one trading day out of approximately 65 in which prices changed more than one percent. During the first quarter of 2018, there were sixteen days with changes of more than one percent and eight days of more than two percent. (Note: these figures show changes from one day’s closing values to the next day’s closing values; they do not reflect days with large price swings intra-day that end up with modest day-to-day changes).

Even with all this increased daily volatility, for the first three months of 2018 the three indexes showed modest changes, at -2.5%, -1.2%, and +2.3%, respectively. These fairly benign quarterly results mask an approximately 11% decline for the S&P 500 from its Jan 26th high to its February 8th low (2,873 to 2,581). Other significant periods of decline on this index since 2000 include:

  • First quarter 2000 to October 2002: 1,527 to 777; 49% decline;
  • End of 2007 to March 2009: 1,468 to 677; 54% decline;
  • April to September 2011: 1,363 to 1,131; 17% decline;
  • May 2015 to end of January 2016: 2,131 to 1,940; 9% decline

The media provides daily reasons for these fluctuations (tariffs, budget deficits, rising interest rates, Trump’s problems), but as we wrote last month, most of the time the reasons are after-the-fact explanations for what is really unknown. The media and financial commentators make the current declines seem greater than they actually are, presenting a sense of urgency, if not emergency, to their audiences. Presumably, the more urgency, the more need to take some sort of action, which is what the media wants (keep tuning in), and the financial community wants (keep making transactions).

At Park Piedmont, we believe this incitement to action is the real downside to volatility. Briefly put, when prices fluctuate excessively, investors tend to want to react to the fluctuations, and to do something. These reactions are often detrimental to achieving their long-term investment goals.

One reaction could be to sell the stocks that are declining. History suggests this is not a good idea, because stocks tend to provide the best results compared to the other liquid investments (namely bonds and cash equivalents) over long time periods.

A significant problem investors face after selling stocks is that they do not know when to buy back into the market. Another problem is triggering capital gains taxes if selling is done in a taxable account. Note that some selling may be warranted as part of a well-developed rebalancing program, but rebalancing should not be occasioned by volatility, but should be established in advance of the periods of extreme price changes.

A second reaction is to buy more stocks at the lower prices, assuming the volatility is to the downside. This may or may not turn out to be a good idea based on what happens to stock prices going forward.  Noting the extent and length of time for some of the periods of decline shown above, this can be a nerve-racking strategy.

Finally, there is the decision to stay the course and rely on the allocation developed in more tranquil times, which allows investors to essentially ignore the short term volatility. This is of course our view, presented consistently over time. But the decision to stay with, or abandon, investments when they are experiencing sharp price declines involves more than objective factors, which is what makes the volatility so dangerous.

In terms of the causes of volatility, we do not believe the frantic daily buying and selling is being done by longer term investors. Rather, we think much of the volatility is the result of traders who use the stock market as a way to make short term bets. These bets have nothing to do with economics, or politics, or finance, but are simply guesses as to where the next price movement will occur. The volatility these traders generate can lead to inappropriate actions by those trying, instead, to use the stock market as a way to grow their money over time.

In our March 2016 Comments, we referenced an article in the “Your Money” section of the NY Times, written by University of Chicago Professor John List. His general point was that, because of loss aversion (defined in detail below), people underinvest in the stock market. They look at their investments too frequently, and when they see declines, they sell their stock positions to avoid further declines. This behavior occurs even though people are aware of the long-term outperformance of stocks.

As List notes, “[m]arket research shows that when your horizon is not today, not next week, but way in the future, the most profitable strategy is to invest more heavily in riskier assets – stocks – than people are prone to do. So why don’t people invest more in stocks? … Because people are loss averse… keenly more aware of losses than comparable gains… So what can be done? Not paying too much attention to your portfolio is a good first step…” More specifically, List’s advice – which he says he follows – is to look at one’s portfolio no more than once every three to six months. (We might ask the Professor: what is the point of checking even that often?)

We think Professor List’s main point is correct. We would add that extreme volatility leads to investors looking at their portfolios much more frequently than is beneficial to them. In the long term, economic growth rates and corporate earnings are the most important drivers of stock prices. They are not a day-to-day story, but play out over extended time frames, which aligns with the preferred, longer-term timeframe for most investment portfolios.

In sum: try to ignore the market’s volatility, as it is likely to lead to thoughts of making (typically unnecessary, often counterproductive) changes. These changes are unlikely to benefit your long-term investment results.