The Market’s Two Speeds

“How did you go bankrupt?” “Two ways. Gradually, then suddenly.”
― Ernest Hemingway, The Sun Also Rises

One of the important truths about investing is that the stock market tends to move at two speeds. Bull markets are long, slow, upwards crawls, while bear markets are sudden, precipitous and painful. These, of course, are generalizations, but they’re sufficiently accurate to merit further discussion.

The reason for this dichotomy is, in my opinion, the market’s fixation on disaster. You can create a small market with 1,000 happy, well-balanced investors; yet when they come together, the collective whole will be a sputtering, neurotic mess. That’s just how markets are. They always hold the suspicion, to a greater or lesser degree, that everything’s a fraud and utter ruin is just around the corner.

I can show this to you in concrete terms. Recently I looked at the S&P 500’s daily performance since 1957. I divided all the days into two groups: those with daily changes greater than 1.25%, and those with changes of less than 1.25%. The direction of the change, up or down, didn’t matter. I only looked at daily volatility.

The results were eye-opening. In terms of market performance, low volatility demolished high volatility. It wasn’t even close. The low-vol group, taken together, accounted for the market’s entire gain spread over 56 years. But the high-volatility days, coming an average of once every seven days, were net losers. Annualized, low volatility returned an average of 8.9% per year, while the high-volatility group lost 5.9% per year.

In simple terms, scared markets are bad markets.

Market gurus enjoy discussing tail risk and the importance of fat tails, but they neglect the other part—the tall peaks. Yet we can see that it’s in these numerous small changes that the difference is truly made.

Investors need to understand that freak-outs happen. They just do. They’re painful because they temporarily confirm and amplify the market’s worst fears.

Fortunately for us, these periodic panics are what give us the value premium. After all, you’re more likely to jump ship from the leakiest vessel. This is why the value premium shows up again and again and again. It’s not some transient anomaly, but rather the direct result of human nature.

Posted by on February 10th, 2014 at 9:18 am


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.