Lessons from volatility, October 2008

This month's tumultuous trading has set records for volatility. The enormous swings in the market threaten to "desensitize" investors in the same way that numbing levels of graphic violence in film and video can desensitize viewers.

Until recently, a three percent move in the stock market in one day (in either direction) would have been a significant move. Now, with moves of five percent, six percent, seven percent and even larger percentages following each other in staggering succession, such moves seem to almost lose their power to shock investors.

Above is a chart showing the trading of the Dow Jones Industrial Average during the month of October, so far (click for a larger diagram to see detail). Each vertical bar depicts one day of trading, with the opening value depicted by a horizontal bar to the left, and the closing value depicted by a horizontal bar to the right. The five up days of October are in green -- all the red days represent down days. During the entire month, there have been no back-to-back positive days for the market to date.

Some particularly volatile swings are shown with greater detail in the small boxes that depict the values for the high, the low, the open and the close.

On October 9, for example, the Dow traded up 2.01% from its open before dropping to close down for a loss of 7.37% from the open (a closing level that was down a total of 9.20% from the high of the session).

On October 10, the high was up 3.88% from the open, the low was 8.01% below the open -- a total of 11.45% below the high of the session.

On October 13, a positive day, the high of the session was 11.41% above the open, and the close was up 11.08% from the open.

These stunning one-day swings are driven by many factors -- forced selling driven by margin calls, mass redemptions from hedge funds that are closing their doors, large sales from mutual funds to meet redemptions by investors, and short-sellers who have been enabled to drive stocks downward more easily due to the unexplainable removal of the long-standing uptick requirement last year. Tremendous increases in computer-driven trading and the decrease of the role of the specialist on the floor of the exchange may also play a factor.

Investors are understandably dismayed by this barrage of unprecedented trading movement and volatility. How can they possibly expect to compete with short-sellers and hedge-fund redemptions?

The answer is that they cannot. In the short run, powerful forces can move stocks around the way hurricane winds toss debris. Short sellers can tear down the price of a company regardless of how solid the long-term business prospects of that company.

But investors do have one advantage over such "fast money" -- the ability to wait. Short sellers and other players who rely on leverage and borrowing (such as hedge funds) cannot sell a company short for years on end -- the nature of such trading is necessarily short-term.

It is obvious that during such a flurry of wild market swings as we have seen this month, the only possible response for an owner of shares in a company he believes in is to hold on to those shares and wait for the madness to pass.

This observation underscores what we have always argued and which we wrote about in this previous post: that it is critical to invest with a philosophy of holding good businesses through cycles, rather than trying to time them.

As T. Rowe Price wrote in 1973, the majority of those who made their fortune in the country did so by owning shares in businesses for many years. He observed that "They did not attempt to sell out and buy back again their ownerships of the businesses through the ups and downs of the business and stock market cycles" (emphasis in the original).

Investors should take the giant swings of this month as a great object lesson. It is obvious that trying to time such moves is impossible, and that investing through them is the best course.

This is what we have believed all along, and applies to other temporary cycles as well.

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