What is the impact of volatility?
An important component of market prices is volatility, meaning the instability of those prices. Volatility is the result of many exogenous factors – as varied as earthquakes, technology breakthroughs or political changes – and endogenous factors such as market sentiment, corporate news or behaviour of buyers and sellers. It is also linked to the great uncertainty inherent to securities valuation.
Under high uncertainty, sentiment and herd behaviour –meaning mimicking your neighbours–can become predominant in short-term market movements. It leads sometimes to overinflated stock prices (also called a ‘bubble’), and sometimes to downward trending, low equity prices (something experts call irrational bear markets).
Is there anything we can predict?
One of the few certainties that we can have is that, in order to sell at the worst possible price (the lowest), one has to sell while the market is going down. Another fact is that, all else being equal, as long as capitalism exists, equity markets are meant to grow, however scary bubbly the path might be. Indeed, the principle of capitalism is capital accumulation, thus richer and richer equity prices.
During periods of stress, erratic behaviours prevail. Someday, the markets will rise again, and the bigger the fall the (few) day(s) before, the sharper the rebound. If you are not invested on the day the markets rebound, you will probably lose an opportunity worth 6 months to one-year worth of investment.
So what should I do?
First, determine if you can still carry the risk of your current asset allocation. But what does risk mean? The ability to potentially lose some money. Therefore, if you do not need that money immediately or or soon enough (meaning you are in a ‘cash-positive’ situation whereby you earn more than you spend and are thus able to save money for the foreseeable future), you should stomach the risk as any further dip in the market will create good buying opportunities.
If you are, however, unable to save easily or potentially need to access that cash in the near term, (that is a you are in a ‘cash-neutral’ or ‘cash-negative situation’), then hopefully you have not taken more risk than you can stand. Meaning not taking bets that could potentially lose you cash when you need it, such as investing in friends’ businesses, illiquid or very volatile stocks you bought because they had been going up for a long time… If you did, then unfortunately it is time to reconsider how far you are from being forced to sell all your risky assets in order to face your financial obligations. If another 10% drop of the markets would put you into financial difficulty or disarray, now is the right time to sell some or all of your equities.
Is it reasonable to invest?
But, to stress, do not be scared to buy equities in the current situation, if you can afford the risk that goes with it. It comes down to your individual circumstances.
Bear in mind that the first thing to do is to determine how much risk you can stand, since taking less than the right amount would drive you toward a smaller risk premium. Conversely taking more than the right amount might force you to sell at the worst possible time. Short-term market movements are mostly ‘noise’ and have little forecasting power.
Lastly, even when you think you are right, invest prudently, and remember Keynes’ famous quote: “Markets can remain irrational a lot longer than you and I can remain solvent”.