Field of play
At times he feels euphoric
From the close on October 27, 2023 to the close on December 14, 2023 the S&P 500 is up about 15%. In this post I propose to discuss what investors should make of this.
J.P. Morgan is reputed to have said, when asked about the course of stock market prices: “They will fluctuate.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p23 Simple and obvious as this observation seems, it contains a truth that investors need to reflect on.
I would say that the run up in the market over the last six weeks is a part of normal stock market volatility. It doesn’t make the stock market a better place to invest. In fact, somewhat to the contrary.
Volatility
Volatility is the up and down swings of the stock market, or of individual stocks, that takes place constantly. Volatility can refer to movements over the course of a day or even part of a day. It can also refer to swings that take place over weeks, months or years.
Benjamin Graham, who taught Warren Buffett a lot of what he knows about investing, tells us: “In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” (Graham, 1973) p101 Volatility is normal, if disconcerting.
View of volatility
My learned instinct when the stock market has run up significantly is that the market has become riskier. Others would say that strength in the market is a sign of future good times and if anything, the market and its outlook is less risky.
This raises an important question about stock market efficiency and the impact of bull and bear markets on investors’ perceptions of risk.
Is today’s price right?
With the market up 15% one might ask if the market is overpriced today. Was the market fairly priced or underpriced on October 27, 2023? Has the true worth of stocks increased 15% in the last six weeks? These are thorny questions.
This raises the question whether the stock market reflects fair value.
In 1980, Robert Shiller wrote a seminal paper titled Do Stock Prices Move too Much to be Justified by Subsequent Changes in Dividends. In the paper he focused on a critical question: “It has often been objected in popular discussions that stock price indexes are too “volatile”, i.e., that the movements in stock price indexes could not realistically be attributed to any objective new information since movements in the indexes are “too big” relative to actual subsequent movements in dividends.” The paper was published in The American Economic Review, Vol. 71, No. 3, (June 1981), PP. 421-436.
Shiller’s conclusion then and in his later book is that much stock market volatility is the result of stock market mispricing of stocks (Shiller, Irrational Exuberance. 2005 Second Edition) p.177.
Mr. Market and Volatility
Benjamin Graham and Warren Buffett have their own explanation of the phenomenon. The following comes from Warren Buffett’s description of “Mr. Market” in the Berkshire Hathaway’s 1987 Annual Report.
“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.” (Emphasis added)
This leads to mispricing and explains a lot of market volatility.
Investors follow the herd
Warren Buffett is reported to have told Congress on June 2, 2010: “Rising prices are a narcotic that affect the reasoning power up and down the line.” (Marks, The most important thing illuminated: Uncommon sense for the thoughtful investor. 2013)p.101 (emphasis added)
Here we get to the heart of it. Stock market prices have risen 15% in the last six weeks. This kind of action can act as a kind of narcotic on investors’ brains. If the stock market were to go up a further 15% in the next six months the narcotic effect would be more pronounced.
Professor Robert Shiller has pointed out that: “the popular notion that the level of market prices is the outcome of a sort of vote by all investors about the true value of the market is just plain wrong. Hardly anyone is really voting. Instead, people are rationally choosing not to, as they see it, waste their time and effort in exercising their judgment about the market, and thus choosing not to exert any independent impact on the market.” (Shiller, Irrational Exuberance. 2005 Second Edition) p.160.
This is why rising prices should make the thoughtful investor more careful.
Volatility Drag
Our subject today is volatility. Investors should know about volatility drag. A rise of 50% is the same as a drop of 33%. Let’s say you have $100 dollars in stocks. Prices drop by 33%. Your paper worth is $66.66. It will take a 50% increase in stock prices to get back to $100.
The same thing works on the upside. If your holdings have gone up from $100 to $115 over the last six weeks, a rise of 15%, it would take a drop of only 13.04% to get you back to $100. Volatility drag is why average returns over a period of time are different from compounded returns.
Fear of volatility can be conquered
Various questions come up about volatility. Should we ignore it? Can and should we try to avoid it? Or even, can we take advantage of it? The answers to these questions should not depend at all on whether we have a negative visceral reaction to volatility. It should depend on what is best for our investment results over the long term.
Ignoring stock market volatility is not a bad course of action. Better though is to take advantage of it. Worst is to seek to avoid it by focusing on buying low volatility stocks.
If an investor really has a bad reaction to volatility, the answer is not to hide one’s head in the sand. It is better to read about it, learn all you can and gradually desensitize yourself to market swings. Fear of spiders can be conquered by learning how many are poisonous in your geographic region and, of the ones that are poisonous (very few), what is the consequence of being bitten: risk of death or something like a mosquito bite. This might be coupled with purposely touching spider webs and even touching or picking up a spider. This approach is somewhat akin to a course of cognitive behavioral therapy.
Conclusion
Serious volatility happens. There are often more risks in strong markets than in weak markets. Many investors are not mentally equipped for such a roller-coaster ride. For those that have the stomach, the rewards can be substantial. It is worth noting that indexing does not remove volatility.
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The starting point for today’s post has been a market rise of 15%. A post I wrote in 2022 followed a 20% market drop. Interested readers can check out the flip side of today’s conditions.
Decisions, decisions and the current down market
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Central to my investment approach is the inefficiency of the stock market. Readers wishing to dig further might look at the Motherlode Chapter 6. Inefficient Market Hypothesis
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And generally, on the subject of extreme volatility, there are these posts:
The great investors and extreme volatility
Keeping your head in times of turmoil
Let’s clear up misunderstandings about risk and volatility
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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