October 2, 2008 - "Why is there so much volatility in the stock market and how should you deal with it?"
Summary:Are you scared by all the volatility in the stock market? Wondering why the market is trading in integer percentages--up 3% one day, down 5% the next day? Read why there is so much volatility and see how to profit from it.
Since Monday, September 22, there has only been one day where the market was up or down less than 1%. Every day, except two days, has seen gains and losses more than 2.5%, including over 5 days of gains and losses of more than 4%. Moves up or down in either direction in these huge increments can be extremely frightening.
There are three major reasons why you see this huge volatility. First, is the commoditization of stocks by Hedge Funds. Hedge Funds have been very bad for the markets since they began proliferating in 2000. Hedge Funds control so much money that they can material impact movements in stocks. Add to the fact that Hedge Funds have an immense burden to show great returns on a MONTHLY basis to investors, they are extremely myopic and short sighted in their trading. They have to trade in the moment and cannot afford to take an outlook 6 months, 1 year, 3 years, or 5 years out. If the stock cannot provide a return instantaneously to them, it is essentially worthless. The power of the stock market is strong. You can make a lot of money buying stocks and shorting stocks, but you need time and patience to be a successful investor. This pressure, combined with a herd mentality for Hedge Funds, is why there is so much volatility in both directions.
Second, the move to electronic trading from floor trading where people traded stocks on the floors of exchanges has greatly increased the speed at which markets move. This is a good thing in the sense that efficiency has been increased and cost of trading has come down significantly-you can now buy a stock for $9 on Charles Schwab when it used to cost hundreds just 10 or 15 years ago. However, because efficiency has been so greatly improved and the amount of money Hedge Funds control has grown astronomically, the movement in stocks has also increased drastically. Money can flow in and out of stocks much quicker, and this is why the volatility has increased so greatly.
Finally, there is a lot of fear in the stock market, and the professional Hedge Funds don't know what to do. The average Hedge Fund is down more than 5% YTD. This might seem good considering the S&P 500 is down over 20%, but Hedge Funds ALWAYS have to win and a 5% loss is unacceptable. They are confused and don't know how to trade this market. The uncertainty and fear in the market is causing sharp drops and moves upwards. Hedge Fund are selling first and asking questions second. Fortunately, this is exactly the kind of fear that Warren Buffett describes creates great opportunities to buy stocks long term.
