You Call that Volatility?

Story Outline

• Memories of past pain tend to fade over time—a natural way our brains protect us. Recent market volatility has many investors spooked, believing it signals bad times ahead.
• Market volatility doesn't signal anything, because volatility is normal and should be expected.

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If you're like us, when you see a big market drop like today, you don't panic. You put your hands on your hips, you look the market (that filthy trickster) straight in the eye and you say, "You call that volatility?"

Human brains evolved to forget the intensity of past fear or pain. We might remember something scared us or hurt, but our memory of the magnitude diminishes. (Ask any woman who's given birth, and she'll confirm this to be true.) It has to be this way! If not, we'd never get out of bed in the morning—we'd remain shuddering under the covers in anticipation of all the world's potential pain.

This is why we tend to misremember our reaction to past market events—thinking we were cool as cucumbers. It's also why many investors, when faced with some difficulty, tend to think, "It's never been this bad." But that can't possibly be true. What about on September 11, when terrorists bombed the very symbol of America's financial might, and we still had no idea who was responsible or if more planes were on the way? What about when Iranian students stormed our Tehran embassy and took Americans hostage at the tail-end of a decade of runaway inflation, record high unemployment, and oil embargoes? Things didn't look so good then. How about when Russian missiles were pointed at our heads from nearby Cuba? How about when Japan bombed our shores in a surprise attack? None of that had investors any more nervous than some folks overextending themselves on their mortgages? Really? When it comes to markets, there's never a dull moment—and yet, market have marched on, hitting new highs, rewarding investors who didn't flee in fear.

We've never seen something this bad, except for all the times before when we did. Just in 1998, we suffered credit crunch woes, currency fears, an imploding hedge fund, and a 20% correction—that had to have been scarier than today—and yet US stocks returned 29% that year. What about that tech bubble? In the summer of 2002, investor sentiment was as bad as it could be—which would have been a great time to hop, both feet, into the market. The world today may seem uncertain, but is it more or less uncertain than when Russia tested an atom bomb in 1949 (S&P 500 returned 19%), New York City went bankrupt in 1975 (37%), or the first Gulf War began in 1991 (31%)?

Facts are, markets are volatile. Headlines proclaiming "It's Different this Time!" and cautioning investors to "do something" in light of today's turbulent markets can seriously steer you astray. Markets are always turbulent! There's nothing unusual about today! We just don't remember it that way. Add that to the unusual lack of volatility of 2004, 2005, and even parts of 2006, and our brains are totally skewed. Average returns aren't normal, normal returns are extreme. This is why stocks tend to deliver superior performance over time (provided you don't panic and abandon them). If equity markets weren't wildly turbulent, you wouldn't get any reward. The US Treasury rate is called the "risk free" rate for a reason—you get a lackluster return for no risk.

When we hear investors say, "It's just so scary today," we're heartened. It's not that we derive Schadenfreude-esque joy from others' discomfort. It's that if folks haven't got anything much more concrete to complain about than volatility, we know fundamentally, the market looks OK. And right now, the market looks fine! GDP growth in Q3 was a big 4.9%—while everyone was moaning that the economy had to be slowing—and global growth continues to look healthy. Interest rates remain historically benign globally. American consumers are wealthier than ever (read "Feel the Flow," 12/11/2007), unemployment is low and wages growing. This is not a time for panic. The best part is there's a complete lack of investor euphoria—and markets love climbing a wall of worry. Yes, credit crunch fears hit Financials in Q3—but that's old news. Markets don't move on what's well known—they move on what's surprising and fundamental, and in aggregate, fundamentals look fine to us. So don't fear the volatility—dare the market to bring it on.