When I first attended college many, many years ago, a college student had a major and stuck to the courses defined by that major. If the course was economics, very seldom would someone find an economics major who also dabbled in psychology - especially child or mass psychology. However, all that has changed. If an economics major can't get a grip on reactionary behaviors, it seems no economic theory in the world will help them explain extreme market volatility. As parents, we might have a better chance to understand this concept, because our children are great instructors. If an economics major observed a few siblings in action, perhaps market volatility would be easier to explain.

Market volatility is an unpredictable and uncontrollable investment risk. In other words, we cannot possibly predict how the market will react to various influences. Nor can we predict how specific stocks within the market will react to various situations. Individual stocks may respond to situations differently than the market responds. Parents see this behavior in action every day. If Susie Q decides to tear the blankets and sheets off every bed in the house, her siblings may very well follow her example. However, sometimes Susie Q will act alone, while her siblings (and sometimes the babysitter) remain glued to the television, blissfully unaware Susie Q is in a destructive mode.

There are many factors that contribute to market volatility. Politics, interest rates, and employment indicators are just a few outside factors that contribute to market and equity volatility. How we react to the media is another contribution to market volatility. When the media reports earnings estimates, management changes, and public relations issues, reporters and journalists are only doing their job. This information is valuable, and without this news investors would be at a disadvantage. Granted, many issues receive much more play than is necessary, and the dissemination of rumors and speculation by media is a problem. However, it is up to us to respond to this information in an appropriate fashion.

What is an appropriate response to a volatile market? This depends on whether the market or specific equities are experiencing a "standard deviation" or a major meltdown. Standard deviations are common and basic measures of volatility that takes into account how equities or the market has responded in the past. This standard deviation does not have a base measurement, so economists often compare equities that are similar to see if the equities behave normally or not in any given situation.

Let's use male twins - Bobbie B. and Eddie C. - as an example to explain this measure of standard deviation. We expect children to take an afternoon nap until they reach a certain age. If the twins historically get heavy lids about 2PM, we can work our schedule around that time frame. When Bobbie B. refuses to get sleepy at 2PM, and Eddie C. is fast asleep, then we begin to observe Bobbie B. If Bobbie B. is sick, then we react accordingly. However, the problem may not be serious, as Eddie C. may also refuse to get sleepy the next day or so. What we have here, then, is a case where the male twins may be old enough to skip the nap. In this case, Bobbie B. simply becomes an early indicator of an overall trend.

This brings another perspective into appropriate responses to market volatility. If we are short-term investors, we may overreact to volatile markets. A short-term investor might immediately overreact to Bobbie B.'s lack of sleepiness with an unneeded trip to the doctor or some other useless and probably pricey (economically and emotionally) solution. A long-term investor would simply observe the problem and wait to see how the scenario plays out. The same thing happens in the market. If a particular equity suddenly climbs or falls, this stock has everyone's attention. Temperatures are taken, analyses are sought, and news coverage is overwhelming. Everyone knows about the problem. This short-term extreme volatility can be devastating and nerve-wracking.

How would a short-term investor react to a mass-sellout of a notable, almost century-old company in reaction to a product failure? This actually happened to one of my investments. The trade was halted and did not resume until the next day. Although I was nervous, I shrugged the event off (although I was grateful the extreme downward movement was halted). I knew what this company was worth, and I also knew the stock would recover. In this circumstance I was correct. The stock resumed trading normally within two days, with no loss by the end of the month. The only reason I had confidence was because I had done my research on the front end and was certain this particular company could survive a major shock.

How can this happen? Economic majors these days are looking beyond economic indicators to explain some of these market fluctuations through mass psychology. News travels faster than ever before, and inexperienced investors can react even more quickly to adverse or positive rumors and indicators. If Susie Q decides to jump off a bridge, it seems a vast majority of people will follow. However, these lemming-like reactions affect short-term profit seekers much more than it affects long-term investors, because - in the long run - the market historically recovers from short-term problems.

Market volatility, like children, will always be with us, and will always be a concern. We cannot insulate our portfolios (or our children) from everything, because most of the impacts that affect our investments are often unforeseen. However, portfolio diversity, front-end research, steady nerves, and a little experience with the unexpected could serve long-term investors well. It might even help us keep our cool when Susie Q decides to repot the house plants in the bath tub.

Until next week,
Linda Goin