The sometimes erratic movements of the stock market can wreak havoc on our emotions - and, perhaps more important, those of our clients. It's hard to forget the 37% plunge of 2008, or the flash crash of May 6, 2010. Almost two years ago, during the four days beginning on Aug. 8, 2011, the S&P 500 changed by an average of 5.1% each day.
More recently, in the waning days of 2012, stocks gave up 3% as Congress steered us toward the fiscal cliff, only to gain it all back (and more) in the last trading day of 2012 and the first trading day of the 2013.
Typical explanations are often rooted in the ideas that the world has become a more volatile place and that supercomputers make thousands of trades a second. These don't seem like too much of a stretch - think of the near-financial collapse of the U.S. economy in the last recession, or the U.S. debt downgrade after political dysfunction raised doubts about our ability to address critical deficit issues. Then there are the perennial bailout crises in Europe and the possible collapse of the euro, the world's second-most-used currency.
These are all legitimate concerns. Yet daily news reports on market volatility can be selective, focused on the most sensational (and downright scary) zigs and zags. Is it possible that our perceptions of market volatility are greatly exaggerated?
RUNNING THE NUMBERS
To help find the answer, Wilshire Associates ran numbers on the volatility of the Wilshire 5000, as measured by its standard deviation. (This index was selected as the best measure of the total U.S. stock market since it includes far more stocks than the S&P 500. Wilshire has collected daily data since 1980.
Using data from the past decade, the charts on the next page break down volatility on an annual, monthly and daily basis.
The first chart shows market volatility on an annual basis. Market swings of more than 30% aren't much more common in the past 10 years than in the previous 23. And on a monthly basis, shown in the second chart, market swings of more than 10% actually appear to be less frequent.
Only on a daily basis, seen in the final chart, does it appear that market volatility increased - but only for a relatively short period of time.
The mean standard deviation of the entire 32-year period is 1.01%. In other words, during 68% of days, the index changed by less than 1.01%, and 95% of days by no more than two standard deviations, or by no more than 2.02%.
Clearly 2008 set a record for volatility, with a standard deviation of more than 2.5% - but the subsequent years were much lower, and not much above the average. Last year, in fact, had lower volatility than the overall average.
Breaking the data into decades, the 1990s were the least volatile decade, with a daily standard deviation of 0.79%, while the 2000s were the most volatile decade, with a 1.29% standard deviation. Though 2008 was by far the most volatile year, 1987 - the year of Black Monday - was more volatile than 2009, which held both the bottom of the greatest bear market since the Depression and the fastest bull ever.
"By any number of measures, the financial crisis was a period of historically high daily market volatility, but not monthly or annual volatility," says Robert Waid, managing director of Wilshire Analytics. "Daily volatility returned to traditional market levels in 2012."
If stocks are only marginally more volatile today, why do many clients perceive much more volatility? Here are a few hypotheses.
* Magnitude effect. On Jan. 2, 2013, the S&P 500 surged 36.23 points. This is a large number, but represents only a 2.54% change in the index. A similar percentage change in 1972, when the index was at 100 points, would come from a mere 2.54-point movement. Although both represent the same amount of movement, we perceive the double-digit point swing as much larger.
* Greater access to information. When markets surge or tank, it's all too easy to get immediate, minute-by-minute information - anywhere, at any time. "Nowadays, you couldn't escape knowing about a big move in the stock market if you tried," says Jason Zweig, the Intelligent Investor columnist for TheWall Street Journal. "Websites, Facebook, Twitter, your TV, your smartphone - all buzzing and beeping green and red arrows at you all day long. Whatever you pay attention to, while you are attending to it, will always seem more significant than it really is."
* Social networking. Humans are herd animals. Studies show that we feel more pain from losing a dollar if we are the only ones who lose; it hurts less if we know our friends have also lost the same amount. Conversely, we don't want to be left out if our friends are making a buck. So while bubbles and panics are not new, social media make it far more efficient for us to know what our friends in the herd are doing.
* Effects of aging. Younger people have less investment capital and more human capital, measured by their ability to earn an income. For many boomer-generation planning clients, the 1987 stock plunge was less painful, not only because they had less money to lose, but also because the plunge had no impact on their human capital. But fast-forward 25 years, and clients are in the chapter of their lives where they may be nearing or in retirement - with little remaining human capital but, hopefully, much more investment capital. As a result, each decline hurts far more than it used to.
Duke University behavioral economist Dan Ariely, author of Predictably Irrational, believes the magnitude effect has support based on studies on "the money illusion," which show that people compute their wealth on nominal dollars - so they are happier making a 10% return with 12% inflation than a 5% return with 3% inflation.
Obviously, the former represents a decrease in real wealth, while the second is an increase. It would be a logical extension, Ariely says, for investors to view a larger point change in an index as more significant than a much smaller change at a different time - even if the latter represented a greater percentage change.
Ariely also agrees that increased information may be bolstering the perception of market volatility. That's because of "availability bias" - the brain's habit of giving greater weight to more salient memories. Market plunges or surges get much more round-the-clock, all-consuming media play now than such events did decades ago - making us more apt to remember both the movements themselves and the pleasure or pain we experienced.
Yet Ariely sees little evidence that social networking has increased the herd effect, pointing out that people don't generally talk about their investments. As for money and age, he notes that people rarely make complex calculations of their own human and investment capital. Although running out of money is a key concern for seniors, he does not believe it translates into perceptions of increased risk.
FEAR OF DECLINE
Other experts suggested different reasons. Meir Statman, finance professor at Santa Clara University, says perceived volatility has more to do with fear and pessimism than with standard deviations. People who think the U.S. is in decline view investing as riskier now than in the past, when they believe the country was better off, he theorizes - and no amount of data showing actual volatility would change their minds.
And Daniel Kahneman, Nobel laureate and Princeton professor emeritus, says he suspects people always think the present is more volatile than the past. Because we know that historic crises have resolved themselves, we may simply remember the past as being less volatile than we viewed it at that time, he suggests. Another factor, he says, may be the absence of a clear, consistent trend in the stock market since the turn of the century. After all, investors tend not to worry as much about volatility when the market is rising.
As with most market action, future volatility is anyone's guess. Facts may not always persuade, but I still show my clients the volatility data, helping to ease their concerns.
It's important to note that no matter what the actual volatility, an advisor's job is to keep asset allocation steady. The data is compelling: When markets reached record volatility and tanked in 2008 and 2009, many investors ran to cash from stocks, and wound up missing the recovery.
If you can't convince clients that there is little evidence of increased volatility, you might just consider giving them more conservative asset allocations - particularly lately, with U.S. stocks at or near an all-time high. With less money in equities, clients may be less likely to panic during the next market plunge.
When it comes to asset allocation, consider sharing this philosophy with your clients: "If you can't be right, at least be consistent."
Allan S. Roth, aFinancial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBSMoneyWatch.com and is an adjunct faculty member at the University of Denver.