When facing the beast... keep calm and carry on

The recent share price volatility has rocked investors all around the world. The FTSE is now officially in correction mode, 11.5% down on just a couple of months ago with another terrifying plunge today. The viciousness of these price falls has led to huge trading volumes on exchanges as stop losses are hit and investors readjust their portfolios for seemingly escalating risk. At times like these shouldn't we just run for the exits?

The beast on wall street

Regular readers will know that I'm a fan of the late Professor Robert Haugen's work. Robert Haugen was one of the great financial academics who railed against the idea of efficient markets. Sadly much of his work has gone underappreciated by his peers due to his tendency for polemic, though more recently the rise of low-volatility funds has seen his star re-emerge.

One of the lesser known books he wrote was titled "Beast on Wall Street... how stock volatility devours our wealth". In it he illustrated with his custom panache how the prices of stocks are far more volatile than their underlying fundamentals can explain. What he found was that price volatility begets price volatility. The market watches and feeds on itself... to such an extent that it tends to be excessively volatile. He called this excess volatility 'the beast'.

During major volatility bursts I frequently get calls from the media asking for an explanation for the stock market's strange behaviour. In the case of 1987, they seemed to want to pin it on the federal deficit. Nonsense... The market was just going through a process of "scaring itself to death". It had done that many times before, and will do it many times again. The key thing to watch for is the dissipation of price-driven volatility. If it goes away things will be fine. And if it doesn't...

It's this excess volatility in the stock market which freaks everyone out, separates weak hands from their holdings and ensures that the stock market remains, on average, under-invested in. One of the main reasons the stock market outperforms other asset classes over the long term is how frightening the beast of volatility can be. It scares most investors off.

The press are of course scratching around to rationalise where this volatility is coming from. Ebola, German GDP, growth stutters, QE tapering etc etc. But this is what Nicholas Naseem Taleb in Black Swan calls the 'narrative fallacy'. We have a limited ability to look at facts without 'forcing a logical link or arrow of relationship upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding.' Haugen was saying quite clearly that sometimes there is no reason, prices can just freak themselves out.

Keeping an eye on the VIX

Rather than being surprised at the market's current volatility it perhaps would perhaps make more sense to consider how anomalously calm it has been recently. One of the key measures of market risk perception is the S&P Volatility Index (or VIX). It hit it's lowest level in July since January 2007 just the credit crunch. Now levels this low were also seen in 1994 before a massive 6 year bull market rise, but nonetheless many perceived this extreme low volatility as calm before a storm.

Volatility

It may be that we are moving into a period of much higher stock price volatility again. Clearly from the chart above spikes this high from periods of low volatility have often led to more volatility. But are we going in to 1990, 1994, 1996 or 2007stylevolatility? Frankly I'm not smart enough to know. What I do know is that if I'm committed to stock market investment as a source of higher returns I have to learn how to live with the beast.

How to live with the beast

The first thing to do is reassessing whether one really should be investing in stocks at all. Thinking of investments like a pyramid, with a wide secure base, and higher risk investments stacked on top can help. Most people need a certain amount of short term liquidity - for bills, purchases, holidays. This stuff shouldn't be invested in the stock market. It should be kept it in cash. Nearer term income requirements should be kept in bonds - secure income streams. The stock market should really only be used as a long term compounding capital growth vehicle - which is where it stands out. Of course we all like to use stocks to speculate, but the beast can devour you so quickly if you are leveraged or overexposed.... be smart.

The second thing to do is to switch off. There is a famous study of Ivy League student investors in the US given demo portfolios to manage. One half were given news and prices daily, the other were given them monthly. It's perhaps little surprise that the investors with less frequent information won. They traded less and were less easily flushed out of their positions at the wrong moment. There's a lot to be said for only checking a portfolio once per year.

The third thing to do is stop trading so much. Stocks are expensive to trade no matter how cheap your broker is. There are taxes, commissions, fees, bid-ask spreads and market impact costs. Volatility encourages over trading. Much of the underperformance of private investors is due to overtrading. The beast makes us trigger happy.

Ride like Dionysus...

At times like this one sympathises with those who feel like running for the exits... after all cash is safe, stable, certain. But if one is investing for the long term and doesn't need short or medium term liquidity what's the point of second guessing the market? The market fools most of the people most of the time. I shall sign off with a quote from one of my favourite mystic writers Joseph Campbell...

"The goal is to live with godlike composure on the full rush of energy, like Dionysus riding the leopard, without being torn to pieces."

Safe investing.

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