The real issue comes down to something very simple – the difference between how individuals and professionals approach stock market volatility.
Most investors head for the hills when volatility rises.
Successful traders, on the other hand, embrace it because they know stock market volatility represents an opportunity.
I find this especially ironic considering how often I hear individuals tell me they invest because they want the “big gains.”
Because most of the time they choke at the very moment when the upside potential is highest. Instead of buying when prices are low, they head for the exits.
This costs them big time.
The Perils of Stock Market Volatility
A 2011 study from DALBAR, a Boston-based research firm, shows that investors achieved a mere 41.9% of the S&P 500’s performance over the 20 years ended December 31, 2010.
In other words, investors left 58.1% on the table.
The DALBAR study also shows that the average investor achieved only 3.8% a year versus the 9.1% annualized returns of the S&P 500 because they tended to jump in and out of the markets at the worst possible moments.
Adding insult to financial injury, Berkeley Finance Professor Terrance Odean’s analysis of more than 10,000 retail brokerage accounts shows that the stocks investors sell tend to outperform the ones they buy.
In fact, Odean found that winning stocks went on to gain an average of 3.4 percentage points more in the year after they were sold than the losers to which investors clung.
The pros have a very different view.
While they do sell on down days, many are also buying, sometimes very heavily depending on their objectives and market outlook.
In contrast to individual investors, who tend to fly by the seat of their pants, the pros I know keep a short list ready of quality companies they want to own.
And they don’t hesitate to add to positions at predetermined price points when the markets get carried out feet first or suffer a protracted downdraft.
Quite a few, including myself, actually prefer to wait for big down days because we know the odds are firmly on our side. It may appear as though we’re timing the markets but nothing is farther from the truth.
We’re simply waiting until we know that we have a quantitative advantage associated with upside potential.
Think about it.
Stocks that have run up are extraordinarily susceptible to a fall. They’re expensive and far more likely to lag the markets or get cheaper than they are to continue into thin air–especially if they’re media darlings.
What’s happening to Apple right now is a good example. After rising 59% this year to a peak of $644, the stock is once again under $600 and has fallen five straight sessions in a row.
Stock Market Volatility and the Other Side of the Trade
People often ask me if there’s any sort of confirming indicator that helps me know if it’s okay to wade into the fray. There is…
When I see a big spike in volume on a heavy down day, I know the stocks I want to buy have likely undergone a change in sentiment amongst the retail investors who are jettisoning them.
This means they are primed for a reversal.
But again, I cannot stress this enough. I really don’t care about “timing.” I am very content to be early to the party or even a little late because I know that changes in sentiment, more often than not, coincide with changes in market direction.
I have studied my market history and behavioral finance. Most individual investors have not, which is why they fall back on their emotions, rather than logic, when the stuff hits the fan.
What I am looking for is the opportunity to beat the “casino” – i.e. the market – at its own game. My goal is to benefit from the absurd decisions of other market participants.
The legendary Jim Rogers has this down to a science.
He doesn’t believe in “timing” either. In fact, Mr. Rogers has referred to himself as the “world’s worst market timer.”
I asked him about this a few years ago. He put it to me very simply: “When everybody goes to the same side of the boat, it’s logical to take the opposite side of the trade.”
My take is similar…when it’s easier to scare the hell out of people than it is to attract them to the markets, the smart money almost always goes long.
People forget that the U.S. stock market – as measured by the Dow Jones Industrial Average using weekly data – fell more than 89% from 1929 to 1932, more than 52% from 1937 to 1942, and more recently experienced a decline of more than 53% from 2008 to 2009. That doesn’t even include the four 40+% declines beginning in 1901, 1906, 1916, and 1973.
Each of them was a great buying opportunity.
Following those epic meltdowns, the markets rose more than 371% from 1929 to 1932, more than 222% from 1949 to 1956, more than 128% from 1937 to 1942, and more than 95.68% in just over two years starting in March 2009 – one of the fastest “melt-ups” in market history.
If you didn’t buy in, you missed out.
Successful Traders Never Fall in Love
Over the years, I’ve observed something else that relates to how investors approach volatility. They tend to think only in terms of rewards.
Most are more concerned with being “right” about an investment than they are about being profitable.
As result, few can think clearly when the markets get bumpy. Fewer still can admit defeat even when doing so may actually save them money.
For example, Professor Odean’s data shows that investors are far more likely to sell winners and incur capital gains than sell losers and avoid them in the first place.
Pros, however, view investments with clinical precision. They tend to wake up each morning wondering what will cause them to lose money that day.
They go to bed asking themselves, “did I manage to avoid those things?”
Successful traders never fall in love with their assets. They don’t care about being right, but place a premium on being profitable. If it takes three or four tries to get it “right” they’re okay with that.
Retail investors constantly hunt for the next best thing. They confuse hype with actual potential.
Many wind up so far behind that they’ll never catch up.
Worse, they grow desperate and take on disproportionately large risks just to break even. Having seen their portfolios cut in half twice in the last decade, that’s the mindset many find themselves in today.
Pros, on the other hand, tend to take measured steps based on carefully defined objectives.
They never lose sight of the fact that stocks are what they are…ownership in a company and the cash flow it generates.
Three Ways to Trade Stock Market Volatility
When things begin to get bumpy, here are three ways to beat the market at its own game.
- Buy the VXX any time the VIX drops under 12. The iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX) reflects the implied volatility of the S&P 500 Index, closely tracking the VIX. Low readings reflect complacency. But to professionals, protracted periods of low volatility suggest things will get rougher ahead. Why doesn’t really matter. What you’re doing with this trade is simply establishing a position ahead of time before the markets experience their next “black swan” event and volatility skyrockets.
- Pick up shares in the RYURX. The Rydex Inverse S&P 500 Strategy Fund (RYURX) rises when the S&P 500 falls. Studies suggest that investing 2% – 5% of overall assets in non-correlated assets like the RYURX can reduce overall portfolio volatility. I think of it in much simpler terms…having a source of profits like the RYURX can help average investors embrace volatility while everybody else panics.
- Create a “Buy” list of 3-5 companies that you would purchase if you got the chance to do so at a deep discount. This could be stocks like Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) or Berkshire Hathaway (NYSE:BRK.A) that are prohibitively expensive under normal market conditions, or simply flyers like the upcoming Facebook IPO. Set aside the required capital if you can and issue the appropriate instructions to your broker ahead of time. Then, celebrate if your order gets filled on a day when most investors will be crying in their beer.
At the end of the day, you can blame anything you want for dismal returns. But in reality the ultimate arbiter stares back at you every morning in the mirror.
History suggests that if you listen to your emotions at every fork in the road, you’ll panic and make decisions that carry you farther away from what you crave most – big returns.
But if you listen to your head and capitalize on the opportunities that chaos creates, chances are that you’ll do all right.
Related: VelocityShares Daily 2x VIX Short-Term ETN (NYSEARCA:TVIX), ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY), ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY), VelocityShares Daily Inverse VIX ST ETN (NYSEARCA:XIV), iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ).