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Saturday 27 August 2011

HONTI #3: Don’t Fear Volatility

Rule #3: Don’t worry about short-term price trends, turn off the portfolio tracker.

"The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances"; Ben Graham, The Intelligent Investor
Imagine if you could pick up the paper every morning and riffle through the pages until you get to the property section where, half way down the third column, you could find the current price of your own home. Imagine further that this price was set by a bunch of people you’ve never met making apparently random bets based on a combination of intuition, centralised economic statistics, a bunch of robots programmed by people with the social skills of a twig and, a couple of times a year, the real price achieved by one of your neighbours actually selling.

Welcome to the world of asset price volatility.

In this situation, day by day, the price of your home would veer about wildly and, if you’re of a nervous disposition, you might lie awake at night wondering if its value would cover your mortgage in the morning. This price variation is what we call volatility and learning to live with its psychological effects is a crucial step in learning how not to invest.  In reality, of course, we don’t have a way of assessing the value of our homes on a daily basis, so we don’t tend to worry about it too much. With the shares we own, on the other hand, we have instantaneous access to what millions of other people think is the right price and this varies from hour to hour and day to day. If you spend your life tracking your portfolio’s valuation this is enough to send you mad.

Nassim Taleb1 describes such an investor, tracking their portfolio in anxious detail:
“A minute by minute examination of his performance means that each day (assuming eight hours per day) he will have 241 pleasurable minutes against 239 unpleasurable ones.”
Take a nice sensible company like Walmart. It’s a big ole’ retailer selling lots of stuff that people need, generally at prices people are able to pay. In the economic jargon a lot of the things Walmart sells are inelastic: you’re going to buy coffee, sugar and bread regardless of what’s happening in the wider economy. So there’s not much reason for Walmart’s price to bounce around yet, at the time of writing, this company’s share price has varied by 20% over the past year. The UK’s equivalent of Walmart, Tesco, has seen a 30% variation. These are some of the biggest and most stable companies in the world: if you see this much volatility in these stocks imagine what you’ll get if you start investing in rare earth miners in Outer Bizarristan? Put another way, if you knew your house was varying in price by up to 30% in a year you’d probably be sleeping a hell of a lot less soundly.

The amount of volatility in markets is puzzling – by some accounts it’s 13 times higher than it should be, according to economic theories2. In fact economists equate volatility with risk: which may seem odd and certainly isn’t what you and I would normally think of as risk3. However, it’s not entirely stupid, because if you need to get your money out of the stockmarket at short notice in order to pay off the negative equity on your rapidly oscillating real estate, then the greater the volatility of your stocks then the greater the risk that you won’t get back what you put back in. Of course, there’s a chance you’d get more rather than less, but you probably don’t want to take that risk with the roof over your head.

This, of course, is why you shouldn’t invest with money you may need in the short term: if some of the world’s strongest and most stable stocks can drop by 20% or 30% for no good reason over the course of a year you definitely can’t rely on getting your money back when you need it. All you really know is that, at some point in the future, you will get a decent return, and that you have no realistic chance of a permanent loss of capital. To put it another way, Walmart or Tesco are not going to go bust and providing you don’t pay too high a price to purchase their stock you should do OK in the long-term.

So avoiding short-term cash calls on your stockmarket investments is a critical learning step, but so is simply learning to deal with the apparently random and often frightening volatility of the market. If you could see your house price valuation varying by the minute you’d probably be pretty worried as well, but ultimately it’s a question of mental balance: if you’re going to fret over natural volatility on a portfolio of stocks you’re going to worry yourself to death.

At the heart of this conundrum is a simple idea – the price of a stock, or your house, at any given point is what other people are prepared to pay for it. Unfortunately the price people are prepared to pay varies for lots of reasons, not all of which are sensible, and you don’t want to be in a situation where you have to sell at prices which are stupidly low. In fact, you want to be doing exactly the opposite and, if at all possible, taking advantage of these prices4.

Of course, human psychology pushes us the other way. The downward spiral of stock prices sets off all sorts of warning signals in our prehistoric brains, telling us to run away from danger and to avoid the pain that comes through seeing our life savings ebbing away5. Psychologically a loss hurts more than a gain. Learning to be a contrarian, to go against the flow, and not to worry about the swings and roundabouts of outrageous stock markets is a key part to becoming an intelligent investor6.

The alternative is to spend every night tossing and turning, waiting for the news in the morning. We don’t do this with houses, so don’t do it with stocks. Daily, weekly and even monthly price movements aren’t relevant to long term wealth. What matters are those quarterly or semi-annual cross-checks on what the real valuation of a company really is. As usual, our behavioral biases are a barrier to a process of sensible valuation.

This problem is even greater than you might think, because volatility tends to spike when we have market crashes and everyone's jittery anyway. This isn’t particularly surprising – markets tend to fluctuate wildly when people can’t get a handle on what’s happening and start to panic. There’s also pretty strong evidence that a lot of investors simply look at prices to judge whether their investments are doing OK or not7. The idea that you can use prices as a signal of corporate health is, unfortunately, about as useful as assuming that you can estimate the cost of your run down shack from the sale of the mansion across the street.

Volatility is simply the outward sign of humanity’s inveterate psychological weaknesses. Learning to love it is probably beyond us, but worrying about it unnecessarily isn’t really going to help. Basically, tracking share prices on a frequent basis is as bad for our mental health as tracking the prices of our homes would be, if we could. We need to check them as often as we need to, which is far, far less often than we really want to.

Unfortunately sometimes the best way of controlling our psychological twitches is simply to practice avoidance. Think of it as a form of tantric investing and learn to control yourself: it’s much more pleasurable in the long run!

Notes to the article:

  1. This is from Taleb’s Fooled By Randomness in which, for some reason, he postulates a fictional dentist that spends his time worrying about his portfolio’s movements. Not great if you’re in for root canal treatment.
  2. See Volatility, the Last Anomaly; particularly the research by Robert Shiller. Basically we don’t understand why stock prices jump around so much.
  3. If you really want to understand this then take a look at Alpha and Beta - Beware Gift Bearing Greeks. You'd probably be better off not bothering, mind you.
  4. See the paper by Larry Summers and colleagues from the link in note 2: there’s darned good reason to think that there are people out there deliberately creating volatility, presumably in the hope of getting you to sell your stocks on the cheap out of fear.
  5. In Of Mice and Templeton Moments we look at the research on how mental anguish can causes physical pain. There’s a lot of mental anguish associated with the visible destruction of your life savings.
  6. See Contrarianism, and half the rest of the articles on the site.
  7. Discussed in Quality Signalling for Quality Stocks. Robert Cialdini’s book, Influence, is a goldmine of startlingly similar ideas. Some of the biological ideas behind why signalling works, or doesn’t, are covered in Advertising on the Handicap Principle, primarily a discussion of economic ideas from George Stigler and Richard Nelson, and the bizarrely counterintuitive handicap principle of Amotz Zahavi.


  1. Great post. One that I will reread again and again.Personal experience has taught me that the method you are suggesting is sound advise.

  2. Easy to say, hard to practice, once you begin trading options...

  3. Great article and so true. As you rightly say if you can't afford short term fluctuations then perhaps you shouldn't be in the market at all. It's all about risk as we explain here