Viewpoints

September 30th, 2015 | by

An Investor’s Cheat Sheet for Market Volatility

Autumn is upon us, but this summer’s considerable market swings are still etched into the short-term memory of investors’ brains. Consider some of the market declines in recent weeks. In just six trading days, from August 17 to August 25, US stocks slumped 11%[i].  Shortly thereafter, the market registered another 3.6% drop in just two days, August 28 and September 1. More recently, from September 16 to 22, stocks shed another 2.6%. Movements such as these grab financial media headlines and frighten some investors, but just how uncommon are they? To answer that question, Gerstein Fisher looked at data going back to 1926.

Exhibit 1 shows the likelihood of upward and downward moves of different magnitudes in the US equity market (keep in mind that volatility can also work in investors’ favor; although, as behavioral finance studies such as those by Daniel Kahneman and Amos Tversky have demonstrated, investors feel the pain of loss twice as severely as the pleasure of gain of the same magnitude). According to the table, the probability of a 4% market decline in six days is 0.052, which implies that during all of the six-day periods since 1926, 5.2% of the time equity market declines have been at least 4%. Since we tend to think in terms of calendar-year periods, it helps to annualize these numbers. Thus, assuming there are 250 business days in a year, 4% six-day market declines happen twice per year on average (the math is: 0.052 x 250/6=2.16). Using this same line of reasoning, we can see that a market decline exceeding 2% over a 4-day period happens about seven times a year (0.118 x250/4)—not as infrequently as investors might think.

But what about the frequency of large market declines, say of 10% and greater? Exhibit 2 depicts the history of such “corrections.” Viewed in this light, market declines are revealed for what they are: an inevitable part of equity investing (remember that long-term investors are generally rewarded with an equity premium for sticking it out through periods of market volatility). For instance, Exhibit 2 shows that, historically, 10% market declines have happened about once every seven months. In other words, the fact that about four years had passed prior to last month’s 10% market slump is something of an anomaly.

But does it mean that the recent 11% market decline in August is a typical market movement? That abrupt decline happened in only six days, so when we go back to Exhibit 1, we find a very low probability of a drop of this magnitude in that amount of time: less than 0.4%, which implies that such an event happens less often than once every 5 ½ years ((1/(0.004 x 250/6))—so surely not “typical.”

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Since we humans are prone to emotions and short-term memory as investors, historical data such as what I’ve just provided can be a useful reality check. I suggest you keep these tables at hand as a guide for those times that volatility rears its head—which it will.

Conclusion

This paper does not aim to define a typical or atypical market movement, but, rather, to help investors see through current market noise and gain a better appreciation for US equity market movements through history. When markets go down, examining this historical data may help investors to remain calm and resist the urge to “bail out” of stocks. In the long run, investors need to adhere to a disciplined investment strategy in order to earn the long-term premium the stock market has to offer.

[i] Based on CRSP US Total Market Index Total Return

 

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