17 Oct 2014 Drive Around Volatility, Not Through It
With all the flashing lights, colorful charts, complicated lingo, computers, algorithms, and statistics associated with the stock and bond markets, it’s pretty easy to think of them as logical, efficient, monolithic machines. But nothing could be further from the truth.
Markets, at their core, are comprised of millions of emotional human beings whose fears on one side and greed on the other struggle against each other in a continual tug-of-war that shapes the seemingly simple prices we see on our iPads or smart phones for everything from aluminum to zinc, Apple to Zillow, or you name it. It’s not a stretch to characterize short-term capital markets caught in buying or selling panics more like they appeared in the movie Trading Places than anything ever said on CNBC. it is simply impossible to explain all the emotions that comprise a market at any given time.
Benjamin Graham summed it up very well many years ago: ‘In the short run markets are voting machines, in the long run they are weighing machines.’ Most of the time, emotion plays a less noticeable role in market movements. When selling or buying panics subside, values return to more reasonable, thought-out levels. But when folks are running for the exits to get out of their investments at any cost or buying into them at any price, it’s hard to adequately explain what’s going on beyond human emotion. The best that can be said is that logic and calm eventually return when the world does not fall apart.
The value of a market, or a company for that matter, in a logical market, is the present value of its expected future returns. But when markets turn emotional, buyers and sellers become lopsided. Stock prices are then set by those in the minority. For instance, in a market where most are selling, the few who buying set the prices by what they are willing to pay.
Emotional sellers who are racing to get their transactions completed will find themselves at the mercy of plodding buyers who are likely doing the tougher work of calculating how recent changes in the economy or company fundamentals impact the purchases they are considering. No doubt, the fire sale prices they are offered excote their emotions a little as well. But the margin for error is clearly on their side.
The S&P 500 is down some 6-8% from its mid-September peak. There is no single new piece of information that everyone says is to blame for the recent volatility. China’s economy is slowing and the demonstrations in Hong Kong don’t help. Europe’s economy is slowing, but it has not been a bastion of strength since 2007. The threat of a global ebola pandemic is in the news daily, but well-educated warnings have been around since April-May for anyone who was paying attention.
The point is, markets turned in September when the weight of negative information finally caught the emotions of enough investors that markets began to turn negative. When other institutions who perhaps were not as forward-looking or saw no problems, decided to join in or be left behind. And when CNBC began to squawk, many millions of their viewers decided to follow suit.
Since its latest peak on September 18th, the S&P 500 is down some 7.22%, but the index remains up 130% from its low on March of 2009. Over the same short time period since the September peak, our Balanced Model index (60% stocks 40% fixed) is down just -3.07% by comparison.
The stock market remains the most powerful long term savings vehicle you can passively invest in on the planet. But it has an unpleasant side effect that rears its ugly head every 4 years or so known as volatility, corrections, bear markets or basically losses of value.
Wise investors begin their investment program with purpose. They start with a plan that represents the sum of their goals and priorities long before they design an investment portfolio. With that plan they have a tool that enables them, among many other things, to determine the appropriate levels of risk, i.e. how much stock (or growth) do they need in their portfolio to confidently meet or exceed their goals?
Knowing their prescribed amount of risk, they are much better prepared to 1) select the right portfolio, and 2) survive the downturns without panic. The latter is made possible by enduring more tolerable losses than those being shouted about on CNBC and bemoaned by friends at social gatherings.
If you don’t have a plan or need to revisit yours, please give us a call.