In our last State of The Economy blog, I wrote about the recent volatility of the stock market. Mr. Mike Sharples, who serves on our board, recently sent his clients a newsletter that put the instability in perspective. His discussion on risk is very insightful. He uses the analogy of swimming with sharks to explain several types of risks. I thought our followers would find his analysis and perspective interesting. Thanks Mike for giving us permission to share your newsletter.
KnowledgeHas the stock market become more volatile these days? So, the stock market is riskier, right? As in all good questions, perspective is important:
A 500-point drop in 1987 was really big news, and even in 2008 it was a bit concerning, but is it significant today given the current DJIA value?
A review of data from 1970 to 2008 for the DJIA showed that percentage of days that the DJIA dropped 2% or more was 2.46%. In addition, over the same period of time (1970-2008) the DJIA moved UP or DOWN 1% or more 24.64% of the time. There are approximately 250 trading days for the stock market over a year:
The volatility numbers for the S & P 500 Index over the same period are very similar. But, do I think the stock market is more volatile today than is normal? No, I think it's back to more normal behavior, it is certainly different than the last couple of years where normal volatility appeared very muted. Until this year we hadn't seen the DJIA drop 5% or more for over 20 months. Welcome back to a normal stock market volatility, at least it appears normal thus far this year. (Sources: Vanguard, Standard and Poor's, and Dow Jones.)
- 6 days out of the year the DJIA will have a drop of 2% or more, based on the data.
- 61 days out of a year it is reasonable to expect the DJIA to move 1% for the day (up or down).
Volatility and Risk are different. There are two kinds of Risk:
What can you do to mitigate Risk? First you can use "Avoidance" strategies; don't swim with hungry man-eating sharks, especially if there's already blood in the water. This would be a pure risk, there's no chance for gain only loss (of life... unless you're the shark of course). Then there are those folks out there that choose to "Retain" that risk by trying to live through this near-death scenario. You might choose a risk "Sharing" strategy by swimming with 100 like-minded ("crazy") people (a.k.a "shark bait") and hope you're one of the ones that makes it out alive. You could choose to use a risk "Reduction" strategy to swim with those man-eating sharks by using a shark cage. "JAWS" put an end to me thinking this was a fool-proof strategy, but it's definitely a "Reduction" strategy. Lastly, you might decide to "Transfer" the risk by paying someone else to go swimming with the man-eaters. In the case of Pure Risk, it seems like Transfer strategies might be a very worthy idea. The practical example of a "transfer" strategy is buying life insurance to mitigate a Pure Risk scenario.
- Speculative Risk is the chance for loss or gain.
- Pure Risk is the chance for loss only.
What about Speculative risk of the stock market, which provides both a chance for loss or for gain. My experience is that most investors would like to reduce the chance of loss but not give up too much of the chance for gains. The first strategy I employ to help reduce the chance for loss while still maintaining good probability for gains is by first setting a reasonable time frame for investing success. As an investor you should have at least a five-year period to invest any money in a stock (or equity-based investment). The longer you can wait for your investment to be successful, the greater the probability of success... I believe it may be a little success or a lot of success, but the goal is a gain and not a loss. The second strategy is to assess the financial strength of the company based on the various company financial reports and analyst reviews based on those reports. The third key is a projection of the earning growth prospects, but this is only a best guess about a company's future success and again carries no guarantees. The guess is based on a company's unique skills, current products, future products, management's abilities, and a projection of the economic environment they will operate in over the next 2-5 years. Lastly, the diversification of the portfolio is also increased by making multiple guesses, investing in many companies that have the positive attributes listed in strategy two and three also potentially strengthens our chances of success over the 5-year (or more) time horizon.
Volatility is about price fluctuation over some period of time. Risk management, with regard to your investment portfolio, is about trying to ensure that your investments are appropriate given your objectives and risk tolerance.
The relatively new field of "Behavior Economics" (R. Thaler) has brought to light what many of us knew (at some level) about ourselves; we all feel the pain of a loss much more strongly than we feel the joy of a gain. The first few losses affect us the most. This may be a bit more evident this time of year for any NCAA Basketball fans. The pain of the last loss in the NCAA Tournament seems to erase all the wins your team (and my team) has piled up during the season. When it applies to our investments, we tend to react more strongly to any downward fluctuation in price than we do when the price swings the same amount in a positive direction. It is in this manner that Volatility and Risk meet. When stock market volatility increases, there's a greater risk of panic on a downswing that an investor sells at a low price point, when in reality nothing has substantially changed from the original decision to invest in the particular company (or companies).
When the stock market appears to be "volatile" keep your perspective of what is normalcy, the quality of your investments, and your time horizon. Don't panic, reassess your probability of gains.
Happy Spring! Happy Easter!
Mike Sharples CFP
3710 University Dr., Suite 130
Durham, NC 27707
Direct: (919) 402-1651 / Toll-free: (877) 744-1651
Cell: (919) 257-0209 / Fax: (919) 402-1655
m.sharples@MKSWealth.comSecurities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC
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