Tuesday, May 21, 2013

How Volatile (Dangerous) Is Today's Stock Market?

Based on conversations with clients, I’d suggest that most investors view the market of the new millennium as more volatile and fragile than it’s been in the past. New concerns that could affect a portfolio are seemingly always coming to light – think of the near-financial collapse of the U.S. economy during the last recession, the U.S. debt downgrade, the potential bailout crises in Europe and the possible devaluation of the euro, domestic unemployment concerns, and the perennial concern about the inflation/deflation of the U.S. dollar.  Add to this the idea that the world has become a more unstable place and the reality that supercomputers make thousands of trades every second.

To determine the validity of these perceptions, Allan Roth analyzed the performance of the Wilshire 5000 (an index of the market value of all stocks actively traded in the United States) since 1980 in the May edition of Financial Planning Magazine. Surprisingly, Mr. Roth found that market swings of more than 30% weren't much more common during the past 10 years than they were from 1980-2002. In fact, on a monthly basis, market swings of more than 10% actually occur less these days than in the past.

On a daily basis, the mean standard deviation of returns (a measure of volatility) over the entire 32-year period was 1.01%. In other words, during 68% of trading days, the index increased or decreased by less than 1.01%. Further, on 95% of trading days the index went up or down by no more than 2.02% (or two standard deviations). While daily standard deviation hit a record in 2008 of more than 2.5%, last year actually had lower volatility than the overall average. Consequently, while volatility hit a high in 2008, it has been at a very normal level since.

So why do many investors perceive much more uncertainty in today’s environment? Mr. Roth mentions a few hypotheses:

  • Magnitude Effect – To suffer a 2.5% decrease in 1972, the S&P 500 would have needed to decrease by 2.54 points. To endure a 2.5% decrease today, the index would need to decrease by 41.25 points. Although both represent the same investment loss, we perceive the double digit point swing as much larger and more dramatic.
  • Availability Bias – Humans overestimate the probability of events associated with memorable or vivid occurrences. Memorable events are further magnified by excessive coverage in the media.  Because the market crash of 2008 was so remarkable, investors tend to overestimate the probability of a similar crash and underestimate the probability of market appreciation, which historical data says is significantly more likely.
  • Access to Information – Jason Zweig, a columnist for the Wall Street Journal, says “today between websites, Facebook, Twitter, the TV and smart phones, an investor couldn't escape knowing about a big move in the stock market if he or she tried. Whatever you pay attention to, while you are attending to it, will always seem more significant than it really is.”
  • Simple Fear and Pessimism – Meir Statman, a finance professor at Santa Clara University, suggests “people who think the U.S. is in decline view investing as riskier now than in the past, when they believe the country was better off, and no amount of data showing actual volatility would change their minds.” Similarly, Daniel Kahneman, a Nobel laureate and Princeton professor suggests “people always think the present is more volatile than the past. Because we know that historic crises have resolved themselves, we may simply remember the past as being less volatile than we viewed it at the time.”
It’s likely beneficial for investors to evaluate their behavior and determine if they exhibit any of these biases.  History tells us that the most dominate factor leading to investment success is to keep your asset allocation steady. Being aware of tendencies that might encourage us to make rash investment decisions could save us a lot of stress during critical market movements.

2 comments:

Cathy Smith said...

Seriously your analysis on stock market tremendously outstanding.Thank you

teresa bowen said...

I like your idea in terms of stock market. Most business owners were started to invest in a stock market because it was one of the most successful business before but now stock market is really volatile maybe due of tons of competitors. In a business, we need to have a reliable financial planning.