The One Word That Explains Market Volatility

Oil prices dropping
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Many investors are looking for an explanation for why the markets have fallen recently. There's no shortage of investment "pros" eager to provide their insights. Regrettably, most "gurus" are overconfident of their ability to forecast what will happen. Investors relying on them are likely to make costly mistakes.

Jim Cramer, host of CNBC's "Mad Money," is typical of investment "gurus" who show little understanding about what actually moves the market. According to Cramer, "Events drive the market now. That means when there is a negative headline, the market tanks. And when there is an absence of negative news, the market bounces."

Here's why he (and many other financial pundits) are fundamentally mistaken.

A Different Perspective on News and the Market

I interviewed my colleague Larry Swedroe and asked him what causes markets to fall. Swedroe is director of research at The BAM Alliance, with which I am also affiliated. He holds an MBA in finance and investment from New York University and has authored or co-authored 13 books on investing. His latest is "Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns With Less Volatility."

As he explains in his book "Think, Act and Invest Like Warren Buffett," whether the news is good or bad has no effect on stock prices. Stock prices already incorporate all knowable information. They went down because news has been bad. The fact there was bad news in the past does not mean stock prices will continue to fall in the future.

It's not current bad news that will drive stock prices. Rather, it's whether the news is better or worse than already expected. If the news is no worse than expected, investors will earn the higher returns that are a result of lower valuations. If the future news is better than expected, but still not good, stock prices should rise.

So here's what actually moves markets: Surprises. By definition, surprises can't be forecast. The likelihood of positive surprises is about the same as negative ones. That's why changes in market valuations are random and unpredictable. Keep this in mind the next time a financial "guru" confidently predicts the future direction of the markets.

A Different Perspective on Bear Markets

No one should be surprised by a bear market, defined as a period where the market goes down 20 percent or more from its high. They have occurred 32 times from 1900 to 2013, or approximately one out of every 3.5 years. The average length of a bear market is 367 days.

I am aware of no credible evidence indicating that anyone has the expertise to time bear markets successfully.

I asked Swedroe how investors should deal with bear markets. In his view, "the key to success is to stay disciplined." He noted the best way to avoid panic selling is to make sure your asset allocation doesn't include assuming more risk than you have the ability, willingness or need to take.

If you don't have a plan and are exposed to excessive stock market risk, you may be in the unenviable position of having to reduce your allocation to equities by selling in a down market. If so, consider your situation to be a wake-up call. It should prompt you to retain an investment adviser who understands basic principles of finance and who will prepare you with a plan to withstand future bear markets.

Follow Buffett's Advice

Ask yourself if Buffett is reacting and following the predictions of the talking heads. Clearly, he isn't. His advice to investors is to "be fearful when others are greedy and greedy only when others are fearful." Why would you ignore his advice and succumb to fear?

Much of the financial media acts irresponsibly when the markets drop. They do so by emphasizing bad news and ignoring good news. The Ebola outbreak in West Africa is a prime example. The few cases of Ebola in this country currently involve individuals who contracted it in West Africa and two health-care workers who were treating one of those people. The possibility of a widespread Ebola epidemic in this country is remote.

You would never get that perspective from listening to the news, which highlights the negative and omits positive developments in containing this deadly virus.

Good News Is Out There

There is positive economic news. The U.S. economy is growing at a faster pace than many expected. The September jobs report was also stronger than expected. And the unemployment rate has fallen to 5.9 percent. Oil prices are down more than 20 percent since June, which should stimulate consumer spending. Interest rates remain at historic lows, providing industry with more opportunities to refinance debt and increase profits. Low interest rates also will encourage refinancing, lower housing payments and permit more people to buy homes.

Swedroe cautions that the global stock markets can continue to fall even in the absence of more bad news. He notes that "markets tend to exhibit momentum, both positive and negative. And right now the momentum is clearly negative." With that said, he offers this advice for investors: Stick to your plan. Avoid panic selling. Engage in disciplined rebalancing.

To which I would add: Ignore most of the financial news, which is calculated to create panic and anxiety and encourage you to act emotionally.

Daniel Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."
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