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EMOTIONS CAN RUIN A WELL CONSTRUCTED PLAN...QUICKLY!

A client emailed me with the subject line…” so the rollercoaster begins!” After years (almost a decade) of historically low volatility, we are beginning to see an uptick of volatility. Given the ups and downs of recent market readings and more importantly, the factors leading to the movement, it might feel like you are on a rollercoaster ride.

Has the market added volatility and more importantly, does it matter?

I compared 20 recent trading days (3/8/18 through 4/6/18) with a similar period a year prior (3/8/17-4/6/17). I used the Dow Jones Industrial Average because it is the Index most frequently mentioned in the media.

During the 2018 period the daily difference between the high and low was:

  • < 100 points: 0
  • Between 100-199:   2
  • 200-299:                  2
  • 300-399:                  6
  • 400-499:                  4
  • 500-599:                  2
  • 600-699:                  1
  • >700:                       3

The lowest fluctuation between daily high and low was 152.9688 (3/20); while the largest was 785.8008 (4/4)

During the 2017 period…

  • < 100 points:            7
  • Between 100-199:   11
  • 200-299:                  1
  • >300:                       1

The lowest fluctuation between daily high and low was 59.70117 (3/29); while the largest was 316.7793 (3/21)

Next, I compared the opening and closing values of the time frames. The difference in 2018 was 920.65 (lower); while the difference in 2017 was 227.7902 (also lower). The answer to the first question…yes, the market is pricing in additional volatility. Now, let’s discuss what that means and how investors can protect against it.

What is market volatility?

When discussing market volatility, most only consider and only care about one side. Volatility readings measure range of change, not direction. Standard deviation measures the probability of a reading or event around a central point (usually the mean). The probability measures both sides equally, but for market participants, the focus is on the left side of the curve.

As uncertainty increases, the potential range of outcomes also increases. A wider range of potential outcomes increase emotions and we know, emotions dictate the markets is the short run. In the longer term, markets tend to be driven by fundamental data. Given the current news cycle, we shouldn’t be surprised market conditions are heavily skewed towards emotional input.

Measuring Volatility

The most well-known measurement of market risk is the CBOE volatility index, commonly referred to as the VIX. The index is often referred to as the ‘fear index.’ The idea behind the ‘fear index’ is that as markets become more uncertain, the implied volatility of options increases. In other words, traders are willing to spend more to protect their stock portfolios and sellers of ‘insurance’ demand more as options are more likely to have value at expiration.

The VIX measures forward looking expectations of the S&P 500 based on option pricing. The index technically measures implied volatility or better said, what market participants are expecting in the next 30 days. By the time you see a spike in the VIX, the market has likely already made its move.

A reading of 15 represents an annual (note annual) expectation that the market will move 15% using one standard deviation (68%). Again, note the movement could be up or down.

More interesting (at least for me), consider the market expectations in October/November of 2008. The index had multiple readings in the high 70s and 80s. Based on the definition, the market was implying returns over the next year could be 80% higher OR lower in the next 12 months…now that’s volatility!

An interesting trade based on current volatility

Emotional trading increases volatility in the short term. The typical knee jerk reaction to the unknown is to avoid it. When considering markets, that means sell and protect capital. This is the ‘safe’ move when the outcome is uncertain. Then, as more information is gathered, an informed decision can be made.

A common factor increasing market volatility today is the ‘unexpected tweet and comment.’ As an example, when President Trump mentioned his desire to impose tariffs, the market fell hundreds of points. He shared specific numbers, industries and countries which added certainty to an uncertain comment. The markets may have brushed off a lesser defined comment. To make matters worse, no one expected the comment. Questions rose quickly…what is the impact to those working in the industries mentioned? How will other countries retaliate?  

We still don’t know the plan for tariffs. Numbers change; exceptions might be made and most importantly, the response from other countries remains uncertain. But, the market quickly learned the initial ‘threat’ is likely less than originally thought as changes are discussed. We return to normal until the next ‘tweet’ or comment.

An interesting trading strategy over the past few weeks (and arguably for the past year) would be to sell (or short) stock based on any negative ‘tweet’ or comment from President Trump and buy the next day (or cover the short). The initial news is a shock to the markets and you know the market does not like shocks or surprises. Markets prefer order.

As the markets digest information, traders reenter if they believe it is safe to do so. In most cases, recent comments appear to be emotional. They are often ‘walked back’ to some extent.

If the ‘tweets’ and/or comments will likely not come to fruition or the damage will be less than originally thought, the trade might be…sell the ‘tweet’! And buy the ‘walk back.’

But be careful. Like most short-term inefficiencies in the market, this trade will eventually stop working. Being on the wrong side of a strategy that no longer works can be devastating.

Back to emotions

If you review the chart for the VIX index, you will notice large spikes that don’t last long (usually a day or two). There may be no better picture of what emotional investing looks like; a large spike of uncertainty and perhaps irrational response with a return to a more normal outlook.

It is important to remember this is a measure of volatility, not a bearish outlook. A scenario where the market consistently falls does not increase volatility. Sadly, in this case, the market has become used to falling values and has priced it in.

The long-term difference between emotional and fundamental

Recent volatility hasn’t affected markets significantly when considering the big picture. For the most part, the reaction to tweets and other emotional reactions have reversed. The tariff example above is a good example.

But, at some point fundamentals will change. When that happens, the reversal often catches investors by surprise. They had been conditioned to ‘buy the dip.’ This may be the most important consideration of this post…ultimately, market conditions are based on fundamental data. It is not based on emotions.

Fundamentals will be covered in my next post. I am reading and hearing (podcasts and interviews) varied opinions surrounding the yield curve. I will share the opinions and more importantly the rationale behind the opinions in the next post. The opinions reveal an interesting perspective on what the yield curve is saying.

Steph handles volatility and uncertainty

As Steph gets older, she encounters an increased amount of volatility and uncertainty. I tell here…welcome to the real world. I could certainly learn from how she handles volatility.

She decided to stop hanging out with a friend who made her uncomfortable. They were great friends for years, but I noticed a change. She wasn’t as enthusiastic as she had been when offering to get together. She explained that the friend swore all the time. She tried to act older and impress others with her ‘adult language.’ Steph wasn’t comfortable with the behavior. She created a rule that I think many might consider.

If her two favorite teachers heard the language used, they would be shocked (her opinion) and more importantly, disappointed by her choice of friends. She didn’t want that to happen. This was wise beyond her years (my opinion).

As you likely know, Steph has recently (I guess we are a few months in) started riding horses. Talk about uncertainty…an animal weighing a thousand pounds or more who has its own brain and, in some cases, does what it wants to do, not necessarily what you want it to do or what you expect it to do.

I’ve watched how trainers work with horses. I think the better ones take the time to know which ones are likely to ‘act out.’ They are prepared for the unexpected. Steph is also watching and learning. She is quickly learning what is expected and what is expected of her when the horse doesn’t do what was expected.

I was sitting with a couple of parents at a recent lesson. Sam (her trainer) yelled…’that wasn’t the horse.’ I looked at the parent next to me and said…’there are only two possibilities…the horse or the rider.’ The parent laughed.

As with all lessons, there is often a lesson beyond what is right in front of you. Learning to work with a horse will likely have an impact far beyond a post, jog, lope (OK. I don’t know what I am talking about…these are words I hear during the lesson). Parents and other riders share the importance of this…as I pull more money out of my pocket.

Long-term solution for market volatility

If you are a trader, you love (and hopefully) profit from short-term market fluctuations. Most investors are not traders and my time on a trading desk revealed most traders should switch to investing, but that is a story for another day. If you are an investor, your solution to potential increased market volatility should be the creation of a financial plan. By the way, there is always the potential for additional market instability.

Your plan will focus on your needs, wants and wishes. In many cases, your wants and wishes are emotionally based. Your needs are fundamental. Therefore, we separate them in most plans.

There will a time when markets do not rebound from short-term ‘emotions.’ Having a plan of how to address the emotional decisions when markets fall is important. During the Great Recession, some clients (not many) considered abandoning their plan as markets fell. Luckily, they had a plan to fall back on.

When questioning whether to take less market risk (extreme case was sell all), my solution was simple. I pulled out their financial plan. We reviewed the key components including the test of ‘bad timing.’ The choice to lower market risk implied a lower return assumption. If we accepted a lower market return assumption, we needed to revisit goals. I would ask…’do you plan to work longer? You’ll start saving more? You decided not to travel when you retire? Or, maybe you plan to die sooner?’

As you might guess…the answer was no, no, no and hopefully no. In that case, we need to stick to the plan. Remember, you created your current financial plan based on what is known today and informed decisions about tomorrow. The decisions made in the plan were made without the conflict of emotions.

If you recognize most market volatility is emotionally driven and short-term, you are more likely to avoid the negative consequences that often accompany emotional decisions and focus on fundamental, informed choices.

To that point, I am working through annual reviews. The review is a great opportunity to change assumptions, update facts and remeasure your probability of success based on informed decisions.

Thanks for reading. Look forward to talking with you soon.

Photo by Aaron Burden on Unsplash