Dealing With Market Volatility

Occasionally, market volatility rears its ugly head. If your asset allocation is right to meet your unique needs and risk tolerance, you can comfortably ignore the day to day gyrations.

Tomorrow may be the best day in market history, or the worst. Probably it will be somewhere in between. Frankly, I don’t have a clue. Normally because of my good healthy ego, I’d have a problem admitting that I am clueless about anything. So, I take solace knowing that no one else has a clue either. I personally may not have the ability to time markets, but if there were anyone out there that could consistently do it, I’m sure it wouldn’t take long for him or her to come to my attention.

If I’m clueless about the direction of the market today or tomorrow, I have a strong belief that the value of the world’s markets will increase over time. I believe that if I hold the world market basket for the long haul, I’ll be amply rewarded for the risk involved. But that means learning to live with market volatility.

One approach to volatility: Market-timing

Anybody can market-time. The airways are full of talking heads with an opinion about market direction. But doing it consistently enough to be profitable is the trick. Markets are almost perfectly random, which absolutely precludes consistent market timing.

Most celebrity market-timers build a reputation based on one or two good calls. This leads investors to believe that market-timing works, which couldn’t be much further from the demonstrated evidence. So, lacking any other strategy, many investors trap themselves in an endless cycle of buying high, selling low, repeating the process and wondering why they don’t make money in the capital markets. If we look at the investors in the aggregate, a clear pattern emerges: market goes up, investors jump in; market goes down, investors bail out. Folks, this is not how to make your dreams come true.

Even famous market-timers eventually flame out. Joe Granville, Elaine Garzarelli, Abby Joseph Cohen, and Marty Zweig all generated a couple of “brilliant” calls and a long term dismal result. The brilliant calls get a lot of publicity, enabling investors in their bad behavior. After their string runs out, disappointed and disillusioned investors turn to yet another guru that the media is only too happy to supply.

Market-timing is emotionally attractive but impossible to implement consistently. Nobody denies that if you could successfully time the market you could eliminate losses and increase rates of return. But, “if” is the biggest problem with the last sentence. There is simply no credible evidence that market-timing can be made to work. And there is lots of evidence that ties unsuccessful attempts to time markets with the dismal result that most individual investors experience.

Because we are not perfectly rational little robots, our emotions can lead us into self destructive behavior. As investors, we are often our own worst enemies.

* Our brains are hard wired to try to find patterns in our surroundings. If we look at random strings of numbers, we will begin to see patterns where none exist.

* A good day in the market doesn’t feel nearly as good as a bad day feels bad, so our pain avoidance bias can overrule our more rational side.

* Most of us are overconfident of our skills in many aspects of our life. A famous study in Sweden found that 70% of drivers felt that they were above average. Similar studies with investors find that they overrate their skills.

* All of us have developed mental shortcuts to help us deal with a myriad of life’s complex problems. Unfortunately, many of these shortcuts, called heuristics, may not stand up to scrutiny.

Couple behavior that sees patterns that don’t exist, irrational pain avoidance, defective mental shortcuts, and overconfidence in our investment skills, and you can see the potential to make bad judgments. We want to believe that we can successfully time the market to avoid any losses even if it flies in the face of all the available evidence.

A more rational approach

It’s liberating to abandon the idea that we can time markets. If we accept that markets are random, and that market-timing is a strategy with a very low probability of success, we can begin to develop appropriate strategies. Strategies that deal realistically with the uncertainty of the markets offer high probabilities of success over the long haul. And after all, it’s the long haul that counts, not just one or two lucky calls.

While the long-term trend of equity markets is decidedly positive, you must accept that any particular day, year, or multi year period is a crap shoot. While there are plenty of bad days, good days outnumber bad days by a wide margin, and cumulative results are quite gratifying. Additionally, risk decreases the longer a volatile asset class is held.

With that in mind, keep enough assets in the safe bucket (short term, high quality bonds) to weather the occasional storm, meet all your short- to mid-term cash flow needs (7 to 10 years) from the account, and sleep well at night. The balance of the assets can be invested in risky assets for the long term. It goes without saying that you will still need to manage the risk of your equity assets so that you get close to an optimum outcome for that part of the portfolio. You are not going to lose your entire principal in a well-diversified portfolio. But, count on it to fluctuate in value. You should also confidently count on it to increase in real value if you hold it for the long term.

Maintaining a long-term discipline is much easier if you know that you need not liquidate any volatile assets to generate the cash for projected expenses well into the future. An adequate rock solid base of safe assets provides a certain sense of serenity during turbulent days on Wall Street. If the near- and mid-term needs are taken care of, mentally you should be able to allow the long term assets to fluctuate without pulling the plug on a perfectly good portfolio at the first sign of trouble.

Nobody likes market volatility. But having a strategy that allows you to live with it comfortably can help maintain the discipline to actually realize the long term potential that equity markets offer. It’s not glamorous, but it works, and it’s the best way to accomplish your financial goals.

Frank Armstrong, CFP, AIFA

Frank Armstrong III is founder and CEO of Investor Solutions, Inc., (www.investorsolutions.com)an independent, fee-only investment management firm in Coconut Grove, Florida. The firm has been named on Bloomberg’s list of Top Wealth Managers, rated a “Five Star” on the Paladin Registry, and selected by Barron’s as one of the top “100 Best” Independent Financial Advisors in the country. Frank has more than 35 years experience in the securities and financial service industry. He contributes to major publications and appears regularly on television and radio. He is the author of the forthcoming book, SINK OR SWIM: Enjoy a Successful Retirement in an Age of Cradle-to-Grave Insecurity and the bestseller, THE INFORMED INVESTOR: A Hype-Free Guide to Constructing a Sound Financial Portfolio.