Invest Despite Volatility

As a noted behavioral economist and advisor to Wealthfront, Meir Statman tells us a lot about how investors react to risk and volatility.

Many investors freeze up when they see headlines about market volatility. They fear they will lose money in unpredictable ups and downs.

This is a mistaken assumption that stems from a classic cognitive error: extrapolating from past events.

People are driven by fear of loss

In this case, says Meir, people are extrapolating from their previous experiences of investment loss to the present day.

A market drop, even a fairly small one, brings up investors’ memories of loss, probably from the 2008 financial crisis. Investors then conclude based on the emotional memory that their outcome will be just as bad as it was in 2008 – when most everyone lost money.

That simply is not the case: There is no reason to believe that this period of volatility signals a big market drop. (Remember: No one can effectively predict big market drops). Thus, the emotion of fear – specifically fear of investment loss – hampers investors’ rational judgment.

“This is not about ‘volatility,’” says Meir, the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University. “It is about losses. The cognitive error is extrapolation from vivid images, such as 2008.”

Deconstruct your fears

Not only is it possible to make money in a volatile market – but, believe it or not, a volatile market and a rising market can be equally likely to work out in your favor.

If your investment horizon is fairly long, then what happens in between doesn’t matter very much as long as your portfolio is ultimately worth more than what you paid.

Markets generally rise over time. So if your investment horizon is fairly long (at least 5 years) then what happens in between doesn’t matter very much as long as your portfolio is ultimately worth more than what you paid for it.

To show you how this works, we prepared an example that demonstrates how an investor in a volatile market actually can come out ahead of an investor in a rising market. We’re showing you these charts because the result is so counterintuitive that we believe it will convince you that your fear of a volatile market is just that: an irrational fear.

You can make money in a volatile market

Take a look at the four tables below, which compare the outcome of purchases in a volatile market and a rising market.

We were inspired to do these by an example cited in Elements of Investing, by our CIO, Burt Malkiel and noted investor Charley Ellis.

In the first of the four tables below we show the price and number of shares of an index-based ETF that an investor might buy in a very volatile stock market if she were to invest only on Jan. 2nd each year:

Table 1: Annual Purchases In A Volatile Market

Purchase Date Amount Invested ETF Purchase Price/ Share # of Shares Purchased
Jan. 2, 2007 $1,000 $100 10.00
Jan. 2, 2008 $1,000 $60 16.67
Jan. 2, 2009 $1,000 $60 16.67
Jan. 2, 2010 $1,000 $100 10.00
Jan. 2, 2011 $1,000 $140 7.14

 

Table 2 shows our investor’s gain per share:

Table 2: Gain In A Volatile Market

Last Value Per Share $140
Average Cost Per Share $82.67
Gain Per Share $57.33

 

Now imagine if our investor faced a steadily rising market over the five years she made her investments. Again, the table below shows the purchase price per share and the number of shares purchased of the same ETF:

Table 3: Annual Purchases In A Rising Market

Purchase Date Amount Invested ETF Purchase Price/ Share # of Shares Purchased
Jan. 2, 2007 $1,000 $100 10.00
Jan. 2, 2008 $1,000 $110 9.09
Jan. 2, 2009 $1,000 $120 8.33
Jan. 2, 2010 $1,000 $130 7.69
Jan. 2, 2011 $1,000 $140 7.14

 

Table 4 shows our investor’s average gain, this time on shares purchased in a rising market:

Table 4: Gain In A Rising Market

Last Value Per Share $140.0
Average Cost Per Share $118.34
Gain Per Share $21.66

 

The bottom line

In this example, our investor made more money by investing steadily in a volatile market (an average of $57.33 vs. $21.66 per share) than she would had she invested steadily in a rising market.

Yet, the volatile market probably looked pretty scary on Jan. 2, 2008, after it had dropped 40%, and even scarier on Jan. 2, 2009, after it had been down 40% for a year.

The point is that interim volatility doesn’t matter; the volatile market actually works to the investor’s advantage because it gives her opportunities to buy at the dips. That doesn’t mean you should wait for a volatile market to invest, of course: A rising market could have been better for the investor depending on the buy and sell dates.

Vivid memories overly affect your judgment

We hope this example shows how little effect current market conditions have on the eventual outcome of your investments. What’s important is making a schedule of regular investments and sticking to it.

Gen Y may be particularly prone to fears about investing, especially because their experience with investing was established during the aftermath of the 2008 financial crisis.

“Young people who had experience with investments that lost money can easily get discouraged and derive the wrong conclusion,” says Meir.

If you let fear keep you from investing, you will miss out on years of returns and more importantly the value of compounding, which is greatest when you are young.

Refraining from investing in a volatile market is yet another example of how what feels right isn’t necessarily the right thing to do when it comes to investing. Let your rational mind guide you: Don’t let your fear of loss take control.

Disclosure

Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security or insurance product. Wealthfront is not a licensed insurance agent. Past performance is no guarantee of future results, and any hypothetical returns, expected returns, or probability projections may not reflect actual future performance. There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed.

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2 Responses to “Invest Despite Volatility”

  1. property investment July 20, 2013 at 7:25 am #

    One of the best investment avenues for individuals is the purchase of the first home. This is also the most common one, as it is most used by the residents of a community. Buying a house is something that everyone plans to do, as it is better than renting a house. The benefits that come along with this are that you build up your equity, gain access to tax advantages and get various opportunities for investment. This not only provides you with a good investment option but also provides a residence for you to live in or rent out as well.

    • Andy Rachleff August 5, 2013 at 3:22 pm #

      We agree that your home can be a very good investment. However it should not be included in your asset allocation. We explained why in Sizing Up Your Home As An Investment.

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