January 20, 2016 – Stock Market Volatility
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
― Benjamin Graham
In other words, there’s always a disconnect between prices and values. In the short run, markets move, sometimes hard and fast — and often very emotionally. When people are afraid, they often sell things for less than they are really worth because they just want to get out. And, similarly, in times of euphoria, people will pay more for things than they are really worth. That leads to wide swings in the prices for things — while the underlying values of them move much more slowly, steadily.
The danger, then, is not that prices swing – they swing both ways – but rather, two consequences of those swings.
One, it’s easy – very easy – to get caught up in either the fear or euphoria and thereby behave exactly opposite of how one ought — it’s easy to buy high during periods of euphoria and sell low during periods of fear, while we all know that the right thing to do is the opposite – to buy low and sell high. The problem is that the prescription is simple but it’s not easy.
The solution to this difficult problem is to temper the emotional aspect by not overreacting to short-term moves, by having reasonable targets derived from a good understanding of your risk tolerance, and — here’s a little bit of magic — by rebalancing to those targets, which last bit is simply an algorithm which encourages you to do exactly the right thing – to buy low and sell high.
Having the right target allocation — which often means having enough non-stock assets to temper the overall volatility of the portfolio, is incredibly important. It’s what keeps you from panicking, it gives you the balancing piece which works in the rebalancing algorithm.
And two – and here is another good place for an aphorism –
“The market can remain irrational longer than you can remain solvent.” — (sometimes attributed to Keynes, sometimes to Shilling, but nobody’s actually pinned it down.)
Meaning that the disconnect between value and price — however irrational it may be — doesn’t help you if you need cash. And can be disastrous for those who are highly leveraged.
The solution to this second problem takes several measures, most importantly, (a) don’t use leverage which can force you to sell things at exactly the wrong time; and (b) have enough cash or extremely-low-risk assets on hand so that when you need to pay bills, you can do so without having to sell stocks, and so you can ride out the periods of fear and not have to sell things for less than you should.
Remember – stocks sometimes go down. And they don’t always do it at a time that’s convenient. We strongly encourage you to review your target asset allocation (what percentage of your portfolio is in stocks or other risky assets) on a regular basis. There’s a trade-off between risk and return, and it’s always important to understand just how much return will be necessary in order for you to achieve your goals – and how much risk it’ll take to have a good chance to get those kinds of returns.
This situation – with stocks going down – should not be a surprise. We anticipate this and it’s exactly why we hold cash, why we don’t generally recommend anyone be 100% in stocks. Look at these market swings and think to yourself that this is part of the process, and should be looked upon as an opportunity rather than a trigger for panic. And, of course, a reminder to regularly revisit goals and risk tolerances.
We provide a sophisticated risk-tolerance tool called Riskalyze. By answering a few questions, people can use it to help figure out how much risk they really are willing to take. Naturally, the result is not a clear prescription — and it gets especially messy when there are multiple goals and time horizons involved, and when there are multiple people involved. Nevertheless, we’ve found it to be a very helpful tool. And it’s especially nice that in addition to testing a person’s risk tolerance, it allows us to actually model that person’s portfolio and see what level of risk that portfolio reflects — and how near or far that portfolio’s risk profile is to the person’s tolerance. If you’d like to take the risk quiz, please click on the following link. There’s no cost, or obligation. And if you’d like to compare your portfolio to the results, please let us know.