The Truth About Those Big Market Swings
(FORTUNE Magazine) – It rivals the New York Senate race--in volatility, that is. So far this year, the Dow has seesawed over 200 points in more than half of all trading sessions, while the Nasdaq has surged or swooned 100-plus points in a remarkable three-quarters of all trading days. For those who think that such big swings are a neon warning sign, it sure looks as if it's time to junk some of those jittery stocks and seek the safety of cash. But rather than reduce your risks, such a strategy may actually add to them.
First of all, things may not be that volatile. Say what? It may seem as if we're facing unusually turbulent times, but over the past 100 years the current level of market shakiness has been more the norm than the exception. True, the size of recent falls has been dramatic. The Dow's 617-point plunge in April goes on record as the largest-ever one-day point fall. But in percentage terms--the only accurate way to compare the magnitude of losses over time--it doesn't even make the top 35 biggest dips, according to calculations by G.W. Schwert at the University of Rochester's Simon School of Business. "What we've seen recently isn't all that exciting in a long-run perspective," says Schwert, who's made a career of studying market swings. "Volatility is certainly higher than in the early part of the '90s, but not exceptionally high."
So why is it so hard to shake the feeling that the market is wilder than George W. during his frat-boy days? A group of finance specialists, including some rather respected names in academia--Burton Malkiel, John Campbell, Martin Lettau, and Yexiao Xu--say they have the answer. Princeton professor Malkiel, regarded as one of the fathers of the index fund and author of the top-selling A Random Walk Down Wall Street, and his fellow economists have analyzed the data and found that while volatility has increased over time, it hasn't been the market that has gotten nuttier, it's been individual stocks. In a working paper for the National Bureau of Economic Research, they show that stocks have become twice as turbulent over the 35-year period ending in December 1997, and that means twice as risky. (Economists use volatility as the best gauge of risk.) Part of that may be due to the fact that today's companies tend to rely on fewer revenue streams than the conglomerates of yore, and that many firms--especially those tech upstarts--are coming to the market too soon for investor financing. There's also the fact that the smallest company revelations are instantly disseminated over the Internet, causing swift reaction by millions of investors, particularly the institutional kind.
But how can individual stocks become more volatile, you ask, without affecting the overall stability of the market? It comes down to the oldest trick in the investing handbook--diversification: When you hold a portfolio of stocks, the unique risk of each investment can balance out. And since the equity market is the sum of all individual stocks, it's the most diversified portfolio you can get. That's not to say the market itself isn't risky. Plenty of things can still go awry with respect to macroeconomic forces like rising interest rates, recessions, and the like. But individual stocks are simply--and always--riskier, because they carry not only their own uncertainty but also the market's with them.
While this may seem little more than a truism, Malkiel and crew's observations have one giant implication for retail investors. Diversification is now more essential than ever. "Most people may think they're pretty well diversified," says co-author Lettau, an economist at the New York Fed. "Our results suggest you might be exposed to much more risk than you think." The answer is to divvy up your equity bets--for example, between 20 to 30 stocks, if not more. (Your mutual fund investments, in all likelihood, are already reasonably well spread out.)
Of course, there's not much you can do about the macro-market risk. Either inflationary pressures or the Fed's medicine will shake things up for a while. But if history is any guide, the overall stock market will trend upward over the long run. As for those nail-biting stocks in your current portfolio, there are two simple ways for you to sleep better at night: Either spread your bets even wider or get the heck out of the market.
Anything in between could leave you worse off.