Behavioral Finance

Vexing Volatility

What can investors take away from December's swings?

December began placidly enough. The S&P 500 rose a hair in the first week. Global stocks fell a smidge. Emerging Markets (EM) stocks were flat. Brent crude oil was down, but West Texas Intermediate (WTI) crude was flattish. Then volatility-in both directions-jumped. Through Thursday, Brent and WTI oil prices are down -20% and -18%, respectively.[i] The Russian ruble, which hasn't been so hot all year, fell -32% more against the dollar in the month through Tuesday, before bouncing back some.[ii] Greek stocks (as measured by the Athex) swung from a 7% gain at the end of December's first week to a -15% loss, before rebounding some the last two days.[iii] Chinese equities sold off big. EM, global and US stocks sold off, falling 9.4%, 4.8% and 4.5%, respectively, through the recent low on Tuesday.[iv] The market volatility index known as the VIX surged, which also means the (bizarre) VIX of VIX surged. Then stocks bounced back big, with two major rallies back-to-back-which, in typical arbitrary form, the media dubbed the "two biggest up days since 2011." That kind of sharp swinging can be tough to stomach. Especially when many headlines point to the more extreme swings (even if they're narrow like Greece) and fret it foreshadows what lies ahead for stocks broadly. However, we believe now is a time to steel your nerve. Markets could always get bouncier. There is no predicting what volatility will or won't do. But reacting to volatility is a common investor mistake. Volatility doesn't predict, and it isn't contagious.

The presumption volatile oil prices, currencies or far-flung indexes are a prelude to volatility elsewhere operates on the notion broad, global markets are unaware of volatility elsewhere. However, equity markets-and the billions of investors trading in equity markets-don't operate from so different a script from bond or commodity markets. Markets, folks, are markets. If most bond or commodity investors know something, equity investors likely know it, too. You can see this in how oil prices, Energy stocks and Energy bonds are all moving in the same direction. Concurrently! That's markets near-simultaneously moving on this widely known information. If a market doesn't reflect big volatility from another market, that isn't necessarily a sign of complacency. It's a sign the broad market impact may not be there. Perhaps it's sector, country or company specific. Heck, gold has been in a bear market since 2011. It's a commodity. Its volatility hasn't been mirrored elsewhere. Same with iron ore. And copper. And natural gas, earlier in this cycle. Greek stocks fell massively through June 2012. Global stocks rose. EM stocks have been really bouncy and overall lackluster since 2011. Global stocks have been booming with relatively little volatility. There is no sign volatility is contagious.

And in markets, volatility doesn't presage more to come. Stock markets-or any market-aren't serially correlated. Volatile times don't necessarily mean more volatile times ahead, and less volatile times don't mean tranquil markets ahead. If that were the case, December wouldn't look like it has thus far. Volatile markets also don't mean smooth sailing ahead, and vice versa. That's a reversion to the mean argument, which also presumes the past predicts future volatility. It's inconvenient, but volatility is totally, completely random. And volatile. You cannot use volatility to predict anything about future volatility or market direction.

Short-term swings are most often investor sentiment-driven. Emotions! And emotions change. Trying to predict the emotions of the bajillion (this isn't an actual number, but you get the idea) investors trading every day is impossible. Reacting to emotional swings that don't predict emotional swings isn't a great investing strategy.

When volatility strikes, we recommend opting out of hyperbolic media coverage. Turn it off. Don't click. Wait until your nerves are cooler to educate yourself. Easier said than done, right? Behavioral finance research like prospect theory shows humans hate losses twice as much as we like gains. When volatility combines with headlines shrieking of Russia's currency collapsing, Greek stocks crashing the most since 1987, oil falling massively or the like, the pain of recent loss meets fear of more loss. It stirs the sense of fight or flight that is our ingrained, biological reaction to threats-how our ancestors survived things like rabid wooly mammoths. But it's perilous in investing. Look, you generally own stocks if you need some measure of longer-term growth. Reacting to short-term volatility means investing based on the past, and in stocks, that probably means selling after a sharp decline. Take it from us, folks, selling when things are down because they're down isn't a recipe for growth.

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[i] Source: FactSet, as of 12/19/2014.

[ii] Ibid.

[iii] Ibid.

[iv] Ibid, MSCI EM and MSCI World net returns for December through 12/18/2014. S&P 500 Total Returns for the same period.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.