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Volatility Tolerance and Market History

AirplaneWindow

Out the Window

I know that I’m unlikely to die in a plane crash. But when I fly, if the turbulence gets a bit nasty, it still freaks me out. One part of my brain knows something (“traveling via plane is relatively safe”), yet another part of my brain is not convinced.

In contrast, my dad is completely undisturbed by turbulence. Why? Because he flies so frequently that he’s become desensitized to it. The part of his brain in charge of fear has experienced turbulence countless times and has seen that it has yet to harm him. He now knows–both on an intellectual level and on a gut instinct level–that turbulence is no big deal.

What does this have to do with investing?

Even a novice investor knows that the stock market has good periods and bad periods. But when you’re checking your 401(k) balance and seeing that it’s down 35% from a year ago, it can be scary. It can be hard to believe that a bull market will eventually come along. (“I know plane rides are supposed to be safe, but I’m still pretty freaked out right now!”)

If, however, you’ve been through a few bear markets before, and you’ve seen the market rebound from each, it’s a lot easier to keep your cool and refrain from getting out of the market at the wrong time. (“Eh…no big deal. Just a little turbulence.”)

How You Can Benefit

Obviously there’s no way to speed up your own experience of bull and bear markets. But you can take the time to read about market history. If you expose your brain to enough examples of market crashes and market rebounds, it will (hopefully) start to get the idea. (My suggestion as a place to start is Bernstein’s Four Pillars of Investing.)

I’m absolutely convinced that through education you can increase your tolerance for volatility, but you can’t do it just by reading a few blog posts. It takes repeated exposure before the subconscious part of your brain (i.e., the part that makes investing decisions 😉 ) catches on.

Added bonus: A deep appreciation of market history should help you not only to keep your cool in bear markets but also to refrain from investing too aggressively during bull markets.

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Comments

  1. This is a fantastic suggestion, Mike. One of my big beefs with the conventional investing advice is that investors are often urged to invest for the long term (which is good advice) but not often given tools or strategies for doing so. It’s not obvious!

    I suggest that people look at the actual year-by-year historical record (available at Robert Shiller’s site). You will find that market downturns that remain in length for any significant period of time always begin at times of insane overvaluation. So, if you want to be able to stick with your plan for the long term, consider going with a lower stock allocation at times of high valuations. There’s a calculator at my web site (The Investor’s Scenario Surfer) that lets you go through 30-year return sequences and to choose your return sequence each year. It’s not real life, but it permits you to see the long-term effects of changing your allocation or failing to do so.

    The goal should be to change your allocation thoughtfully, not in response to panic over surprise price drops.

    Rob

  2. I’d just add that at the moment the problem is people don’t understand the good times could return someday.

    Even investors who saw the Dow double every 3-5 years in the 80s and 90s seem to expect at best 5% returns ad infinitum from here.

    On a long-term context, it’s important to understand how heady things can get (and roll with it) as it is to avoid being spooked out by the lows.

  3. Thanks for the tips, Mike! It does make a great deal of sense when you sit back dispassionately like I am now. In 5 years time when I’m staring down at a 35% loss, maybe not so.

    I’m going to write on my ‘trading wall’ (my office wall…) in big bold letters: “DO NOTHING”.

    Well, when I have an office and some shares I will. But one step at a time, right?

  4. So are you saying it’s easier to ignore the noise if you’re old?
    Ahem!
    The concept of fastening a seat belt and holding on works despite my youth! ( And clutching a pillow to my stomach helps a *whole* lot!)

  5. Yeah, timing has always been my challenge. If I don’t invest for the long run (buy, store in file cabinet and forget my investments for years), I will end up buying high and selling low.

  6. Good post Mike.

    You have to be realistic in your long term expectations though. Over 30 year annualized real returns of US equities, the lowest since 1930 is about 1.5%, the highest is about 10.5%. Lets just hope that we don’t see another 1.5% annualized 30 year period when we retire! FYI that was in 1931 and 1932.

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