Stock Market Volatility Is Natural

The past three weeks have been “interesting.”  As in the Chinese curse, “May you live in interesting times.”  Should we pay much attention?  Should we take action?  Do we even understand volatility?

I would like to suggest that understanding is an important first step.  Action and attention may or may not follow.

If we focus on daily returns we will be mislead.  Daily changes are highly volatile because they are emotional.  The frequency chart that arises looks a little like a normal distribution, (bell curve) but it peaks higher and is narrower in the middle.  (The average day is more common that you would think.)  More important, it has heavy tails.  Lumps at the extremes.

This article on risk measurement is useful.  The graphic is from it.

sp500-index-daily-return-actual-vs-predicted

 

On the right side we have a frequency that is too high to be from a normal distribution.  That high frequency lump represents greed.  The market is rising sharply because it is rising sharply and it is human to want to participate.  Fear of missing out.  At the left side there is another lump with high frequency.  The fear factor.  The market is going down because it is going down.  Owners of securities believe they have made a mistake and exit before they lose more.   The sky is falling fear.

Neither extreme notices business fundamentals.  Fundamentals are less changeable.  Microsoft at $50 per share is pretty much the same business as it is at $40 or $60.  The reason for the price change has to do with the nature of the stock market.

The stock market is an auction market. Auctions determine price not value.

The price is based on supply and demand and those are influenced by fear and greed.  Motivated participants. In the short run, price has little to do with the fundamentals of the underlying business.  Warren Buffett has describes the market as bipolar.

The economy and individual businesses are unaffected by a price setting mechanism.  If the price of your home changed by 5% today, would it change your use and enjoyment?  Probably not.  Especially so if it might recover the 5% in 90 days.  You might not notice.

Prices are driven by emotion and as such represent the noise around the real value of  fundamentals.  It is like static on AM radio.  There is the signal, the fundamental value, and there is the static.  Noise.  Interference.  Volatility if you will.  Years ago, when you listened to distant radio stations you came to ignore the static and focus on the signal. Now is a time to do that same thing.

Focus on the fundamentals of your business investments and understand that the volatility is an effect generated by the pricing mechanism, not by the business and not by the economy.

It is a mistake to see a day-to-day price change effect and assume there is a cause other than the emotions of the auction participants.

“The stock market is a device to move money from impatient people to patient people.”  Warren Buffett

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Contact: don@moneyfyi.com

This entry was posted in Decision Making, Investing, Personal Finance and tagged , , , , . Bookmark the permalink.

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