Market volatility doesn’t matter in some academic sense. That is some formal relationship between volatility and returns. Volatility matters because it wreaks havoc people’s emotions. Phil Pearlman has a great post up talking about how the financial media deals with market declines:
I have seen these articles every stock market correction forever and they are all useless….So go ahead and read them all if they make you feel a little less bad about losing your money or maybe have a drink. You are going to do what you are going to do.
Market volatility as measured by the mix has had a big spike upwards, some 20% above its 10 day moving average. Volatility Made Simple shows that even after a big spike upwards the VIX can continue higher. The slope of the VIX futures curve also shows a big spike in fear as well according to Humble Student. This is of course great for premium sellers according to NAS Trading. The situation is the same in Europe as well as their VIX measure has more than doubled in the past month and is at its highest level since the eurozone crisis according to the FT.
What does this all mean then for traders and investors? Brett Steenbarger at TraderFeed talks about just much rising volatility affects a trader not ready to adjust to reality. He writes:
When volatility increases by several orders of magnitude, not only are the moves in the direction of the trend accentuated, but also the moves against the trend. That means it’s very easy to have a trade move 1% against you in minutes, where it would have taken a few days for such a move to materialize in the slower, low volatility market. If your trading size is the same in a high volatility market as a low volatility one, you have effectively magnified your size by several times. That does not mesh well with many people’s risk tolerance.
Investors as well have to deal with the consequences of market volatility. As Rick Ferri notes there is little long term investors can or should do in the face of a market correction. He writes:
If you feel the urge to exit the market during a volatile period, you would do well to remember that you picked your equity allocation willingly and likely during a period when you weren’t emotional. No one forced you to pick this spot on the risk-and-return curve. You did it in good conscience and for good reason. The trick is to recognize Kahneman’s observation that the fear of loss is more powerful than the joy of a gain, and that you’re experiencing that now.
Per Pearlman’s earlier quote that is easier said than done. The best you can do is take a step (or two) back from the markets and assess things with a bit of dispassion. This self-awareness is crucial in preventing you from doing additional damage to your portfolio from hasty decisions. The following quote from my book still captures what I think is the right approach for most investors:
The great challenge for investors isn’t putting together a strategy; it is putting together a strategy that they can follow. Every strategy will require some tweaking over time, but investors almost always get into trouble when they adjust their plans during times of market stress. It is always better to be proactive, rather than reactive, and avoid making major decisions when we are under stress and suffering decision fatigue. In the end, we are better off with a suboptimal strategy that we can follow, rather than one we don’t fully understand and will abandon at the first sign of trouble.