The Volatility Trap: Why Staying the Course Makes Sense

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Leonard Gerber, a 65-year old financial planner, has seen plenty of volatile markets during his career. But this one feels different.

Across the country, investors are fleeing the stock market for the safety of cash. On Tuesday the Standard & Poor's 500-stock index lost as much as 2.2% before a late-day rally sent the index up 2.3% for the session. In the 46 trading days since the beginning of August, the S&P 500 has seen 29 swings of 1% or more.

Tuesday is a "perfect example" of why Mr. Gerber has bailed out. "The market is manic," he says. "There's no consistency ... and there's a worrisome amount of volatility."

The Wall Street Journal, October 5, 2011

Those who let emotions drive their investment decisions, as happened with Mr. Gerber and millions of others, missed out on the October market surge, the largest monthly stock market return in 20 years. These investors have unwittingly fallen prey to the “Volatility Trap,” failing to recognize – as our data show – that increased volatility is a precursor to higher returns.

Advisors are at the center of the volatility firestorm. Panicked clients call demanding relief and the simplest solution is to sell their equity position. Those advisors who believe stocks are the best long-term investment are forced to talk distraught clients down from rash decisions. The more ammunition advisors have for these heated discussions, the better.

In a previous article, Keeping Volatility in Perspective, we presented a long-term argument for staying the course in equities. If the advisor believes stocks have the best long-term expected return relative to other asset classes, then it is in the client’s interest to stay invested in stocks. So the volatility discussion revolves around the issue of short-term anxiety versus long-term benefit. In this article we present evidence that there is not only a long-term benefit but also a short-term benefit to staying the course.

The Volatility Trap

The Volatility Trap, portrayed in Figure 1, captures the dynamics of market volatility and return over time. Time zero, the present, separates the recent past (the left side of the figure) from the near future (the right). While the stock market has just been through a period of high volatility and below-average returns, the right side represents a near future in which volatility is typically lower and market returns are above average. We will demonstrate that markets routinely work this way. 

The emotional reaction to volatility turns this into a trap. The Volatility Trap

The Volatility Trap is driven by the empirical observation that, even though investors have recently suffered increased volatility and lower or even negative returns, future volatility will most likely lessen and market returns will often be above average. (This is common sense which is often forgotten in the heat of the moment – abnormally high volatility must at some point revert to more reasonable levels, just as below-average returns must rise.) As strong as is the urge to bolt the market, the rational decision is to stay the course or even increase equity holdings. If the investor falls into the Volatility Trap by abandoning the stock market, they compound their misery by missing out on higher future returns.

Resisting the impulse to decrease market exposure in the face of increased volatility is counterintuitive, of course.  It cries out for empirical support, a task to which we now turn.