Market volatility is here to stay.
Over the past few months, the Dow has faced triple-digit swings on multiple occasions, and while day traders might be delighted, average investors are gagging. Volatility, towards peaks as well as valleys, is making investors anxious. But it may be the new normal.
To understand why we’ve seen so much volatility lately, and why it’s unlikely to go away any time soon, we should first examine the causes. Some of them, such as worries about Europe’s financial stability or reactions to our current state of political gridlock, are tied to current events that will change over time. John Bollinger, president of investment management firm BollingerBands.com, told USA Today that “Volatility […] is basically a function of uncertainty.” But many of the fundamental causes won’t vanish so quickly, if at all.
Increased technology is one of the primary driving forces behind the upswing in market volatility. The availability of technology has amplified rapid trading, and models of the market can be reconfigured with staggering speed. Larry Tabb, the president of the research firm Tabb Group, calculates that “high-frequency trading makes up 53 percent of all trading in U.S. stock markets,” CNN Money reported in August. Bloomberg recently claimed that it was 75 percent. What is undisputable is that the percentage is large, and getting larger – and that the trades are getting faster. Bloomberg reported that the fastest trades are currently made in 10 microseconds.
In addition to fast trades, lower transaction costs have reduced an historical impediment to making frequent trades. For instance, an average investor in the 1980s would pay $150 to trade a few hundred shares of a stock. Now discount brokers charge $8 commissions for online trades of any size.
The increased popularity of exchange-traded funds (ETFs) enables quick, directional bets. Their evolution is a market enhancement. But leveraged ETFs are not. These types of securities use borrowed funds, providing both professional and non-professional investors with an easy way to make amplified bets. These amplified bets double or triple investors’ gains or losses, which magnifies market movements.
All of these are changes to the structure of the way people make trades, and none of them are going anywhere any time soon. Even in the shorter-term, the political factors do not seem likely to resolve quickly, nor does it seem like Bollinger’s culprit, uncertainty, will soon disperse.
What, then, does sustained volatility mean for the average investor?
Today, it is harder than ever to ignore the financial volatility. As recently as 25 years ago, the only way to track the stock market was to open the business section of a newspaper. Now, it can easily seem like Wall Street is stalking you. National Public Radio announces the state of the market at the top of every hour; 24-hour news channels come standard with tickers or, at the very least, green up or red down arrows at the bottom of the screen; even elevators in major buildings display market performance right next to the weather. Tickers have also become fixtures of many metropolitan buildings, from those in Times Square to the one on the Merrill Lynch building in the Capitol Square in Madison, Wis.
Many investors now have constant market information through their smartphones and other Internet-equipped devices, and more people than ever feel obliged to stay aware of market fluctuations. Some of this can be attributed to the do-it-yourself spirit promulgated by national brokerages, such as Schwab and E-Trade. But it may also be the result of the shift from traditional defined-benefit pension plans to defined-contribution plans. More people than ever before are responsible for investing their own retirement funds; of course these people will want to monitor their investments.
When the market is this volatile over an extended period, and when you are constantly aware of its movements, it’s tempting to try to avoid losses while still seeking gains. This tendency often leads to emotional decisions, rather than rational ones. My colleague Benjamin Sullivan recently wrote in depth about the danger of allowing emotional reactions to dictate investment decisions. When you are surrounded by messages about the state of the market that always seem to end in exclamation points, it’s easy to lose a dispassionate perspective. But doing so is often a costly mistake.
The market is doing what it has always done: fluctuate. The scale on which it is doing so has amplified, and that doesn’t seem likely to change. This new normal can magnify both successes and failures. For investors, it’s more important than ever not to try and outsmart a market in flux. Mistakes can cost more than ever.
Truth be told, increased volatility can actually help a disciplined approach. As the market swoons, it creates more opportunities to buy low and sell high. Clients whose stock weightings declined and fixed-income weightings rose during this summer’s market sell-off provided us with the opportunity to buy stocks at lower prices before the October rally.
Such disciplined moves should lead to better returns. Selling when everyone else is selling and buying when everyone else is buying guarantees poor ones.