Avoiding Stock Market Whiplash

Stock market volatility is on the rise!  At least it seems that way.  The last couple of weeks have seen some series whiplash inducing stock market moves, both in the positive and negative direction.

Large enough and violent enough moves to put fear into the heart of almost any investor.

Some of my investments weathered the storm just fine, only slightly lower than two weeks ago.  But a couple are sitting at new-52 week lows.  We hold a mix of index funds, stocks, and preferred shares — as a result our portfolio suffered through the same wild gyrations as the rest of the market.

So, does all this volatility mean I’m looking through the “help wanted” ads for a new job?

No!  Not yet anyway.

Instead, I thought it might be fun to discuss some of the more common myths and misconceptions investors often have around these large stock price moves…

“I’m Losing Money!”

One of the biggest misconceptions I hear from small investors when volatile price changes happen is “My net worth is down, and I’m losing money!” or “I’m going to take my gains before the market really crashes and I lose money.”

This kind of thinking is complete nonsense.  Your net worth calculation may have changed, but you didn’t “lose” any money.  Mr. Market didn’t break into your house and steal all your cash hidden in the underwear drawer.

What you actually hold are shares, NOT money.  You traded your money for shares (or units in a fund).  Market prices are merely a reflection of the current offer for more shares.  It might be less than what you paid, but so what?

Look at it this way — Imagine you’re outside your house mowing the lawn (just minding your own business), when suddenly this crazy guy named Mr. Market walks up and starts offering stupid-low prices for your home.  Would you take him up on it?

Of course not!  Your house has utility value to you outside the stupid-low price Mr. Market offers.  You live in that house.  It’s your home.  You clearly wouldn’t want to sell it at a disadvantageous price.

It’s the same for stocks.  Stocks and index funds have utility outside the currently quoted price.  We buy these little pieces of a businesses because they have earning power and the potential for earnings well into the future.

Some investments even pay out regular income to owners in the form of dividends.  In my case, I now collect over $50k in dividends annually and (almost) every year those dividends grow a little.

Some academics would have you believe that quoted share prices always accurately reflect the investment’s earning power, but there’s clearly a difference between stuffy professors who publish academic papers and investors who actually live (and invest) in the real world.   Share prices can sometimes become unhinged from true “intrinsic value”.

Obviously, the current and future earning power of a business can’t fluctuate by 10% in a matter of 3 days.  Nor can the accountant’s version of business valuation (assets – liabilities = book value).  Three days is just way too little time for major valuation changes to occur.

Something else must be going on when prices vary this much (and this quickly).  Is Mr. Market being irrational?

“It’s a Crash!  No, It’s a Correction!”

One of the biggest bits of hyperbole I’ve saw printed this week in the news was this —

“We’re in the middle of a market crash!” 

OR

“This is just the start of a big correction!”

The financial press loves exciting headlines, but they’re clearly trying to predict the future when they have no ability to do so.  If they could really predict the future, they sure as hell wouldn’t be working at CNBC or other news outlet.

They’d be a billionaire sitting on a yacht somewhere if they could truly predict what was going to happen next.

The truth is nobody knows what’s going to happen next.  As I write this, the S&P 500 is still positive for the year — up 2.67%.  I wouldn’t consider that a crash or even a correction.  Hell, that’s not even a loss for the year!  It’s complete hyperbole I tell you!

Furthermore, the predictions of a crash seem greatly exaggerated when we take the scale of previous corrections and crashes into context.  This is barely a blip in the grand scheme of stock market movements.

I suppose it is possible — a correction could happen.  A crash could also happen.  The market might also go on to enjoy a 10% gain for the year.

Nobody knows!

“The Stock Market Is Riskier Now”

Here’s another myth I see perpetuated every time the market does a little extra large price wiggling — That greater volatility means greater risk for investors that own stocks.

The easiest way to understand why this idea is wrong, is to think back to our earlier model of Mr. Market shouting out offers to buy a home…

After hearing these ridiculous offers from Mr. Market, the homeowner goes inside and asks his wife, “Honey, is owning our home riskier now that we have a crazy man outside offering wildly varying prices every day?”

The wife replies, “Well, do we still have our jobs?”

“Yes”, says the husband.

The wife patiently continues, “Do we still have our 1 year cash cushion?”

“Yep”

“Is there any way that crazy Mr. Market can get inside or cause damage to the house?”

“I don’t think so… he seems pretty harmless.  He’s just standing on the street” says the husband.

“Then I don’t see how his price offers could possibly increase the risk of owning our home.  He might scare the neighbors into selling at a low price, but we intend to live here a really long time.  It really won’t bother us.”

And this is exactly how investors should think about the “risk” of price volatility.  Under most situations market volatility does not affect the long-term underlying economics of the business — only the current stock price.

This scenario also teaches interesting lessons about finding low-risk investments:

• A low-risk investment should have stable earning power.
• The investment should also have plenty of extra cash on-hand to cover fixed payments.
• Debt levels should be low relative to asset and income levels.
• A low-risk investment doesn’t need the stock market for funding.

“Do Rising Rates Mean I Should Invest In Bonds?”

With rising interest rates, I see a lot more calls for investors to consider bonds, CDs, savings accounts and other low risk financial instruments.

To some extent this is true — Rising rates will improve returns on CDs and savings accounts.  Existing bonds will drop to match higher prevailing interest rates, and new bond issues will have higher rates offered to new investors.

There’s absolutely nothing wrong with investing in these low risk instruments, but it’s also true that equities (stocks) will outperform bonds and other low-risk investments over the very long term.  Yes, there might be time periods where bonds do outperform equities, but eventually equities will produce a greater return over a long enough time horizon.

There’s considerable historical data which supports this idea — you can find very well covered in books like Jeremy Siegel’s Stocks For The Long Run.

Intuitively this also makes complete sense because businesses (aka equities) borrow at prevailing interest rates to invest and grow their business.  If they can’t realize a return greater than that interest rate, then they absolutely should not be borrowing money.

Thus, equities should eventually outperform bonds if credit markets are functioning properly and businesses are still able to grow profitably.

Simple, no?

Final Thoughts

So there you go — under most circumstances additional stock price volatility is not harmful to investors.  Most of the time it’s simply a non-event.  There’s absolutely no reason to feel scared or depressed when the market changes prices erratically.

You didn’t really lose any money, and last week’s price moves are not indicative of tomorrow’s prices moves.

It’s just a normal part of how markets work.  Volatility is part of the game.  If you’re a long-term investor and volatility bothers you, then I suggest just NOT looking at stock prices.  Seriously — just don’t look.

If you have no intention of selling your investments for a decade, then there’s absolutely no reason why you would need to look at the stock price.  It’s not the stock price today, but the stock price in a decade that actually matters to you.

Even then, it can be really hard to completely tune-out the market noise.  It’s times like these that I always try to remember that famous quote attributed to Benjamin Graham:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Remember folks — keep thinking long term.

[Image Credit: Wikimedia, Flickr]