Why Volatility Makes Investing So Difficult

Why Volatility Makes Investing So Difficult

Whenever stock prices take a hit, volatility generally increases. By that I mean daily price swings become more extreme – both in size as well as in speed – as compared to longer-term averages. That’s the situation in which we found ourselves after COVID-19 decimated world economies. When was the last time you saw the S&P 500 go up and down 3% or more each day for weeks at a time? (Hint: it was in 2008). Why do we find it so much more difficult to make investment decisions during periods of extreme volatility? There are several reasons.

The overall challenge is getting our rational thought process to overcome our more dominant emotional thinking. It’s difficult to slow down and apply sound, intellectual analytical principles to our decision-making when the market is gyrating wildly and our brains are screaming to do something right now to reduce the uncertainty. The behavioral bias known as loss aversion is also a factor. It refers to people’s preference to avoid losses over acquiring equivalent gains. It’s why we experience such emotional turbulence (that extreme desire to act) when the market is in freefall but not when it’s climbing. In the latter case we merely bask in the happy feeling of becoming wealthier.

There’s also the mathematics of volatility that adds to the difficulty. Remember that investing isn’t about jumping into the market for a short time, becoming rich, and then transferring your winnings (if you’re lucky) to the bank afterwards. That’s gambling. Investing is growing your savings in a managed, careful way for the long-term. Which means that whenever you sell some investment, you generally need to buy another one to replace it. Whether you invest in individual stocks, ETFs, or mutual funds, it normally takes at least two days to complete a sell and replacement buy trade due to trade settlement timing. When prices are fluctuating less than 1% each day, no problem. But you don’t have that luxury when prices are see-sawing by more than 3% daily or even hourly. In such an environment the replacement fund could end up costing you a pretty exorbitant premium if you have to wait a day or two before buying it. And if the investment that you’re selling is an open-ended mutual fund, you won’t know its net asset value (the price you’ll get for it) until the end of the trading day. That price could turn out to be a lot lower than expected during volatile periods even when market close is only an hour away.

The fear of making a mistake is also exacerbated when the range of prices becomes much greater. Its scope derives from recency bias (another behavioral emotion) which causes us to base future expectations on more recent experiences rather than over the longer-term. When the difference between average daily stock market highs and lows is narrow (such as it was in 2017), this fear is reduced. The reverse is true during periods of greater volatility such as today. Your fear of loss if the market should drop after buying an S&P 500 index fund would have been much lower in 2017 as compared to buying the same fund today. And your fear of missed opportunity by selling such a fund just before the market takes off is a lot higher now than it would have been in 2017. In short, a mistake in either direction has much greater perceived consequences when volatility is high.

History shows us that volatility tends to cluster around market lows. The biggest “down” days as well as the biggest “up” days occur just before and just after market bottoms, much like earthquake aftershocks. Trading in either direction after markets have declined can be more difficult because of the increased volatility that accompanies such events.

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