Avoiding the Low Volatility Trap

Stock market volatility—how much the market goes up and down on a daily basis—has recently been unusually low. Since July of last year the S&P 500 index of large US stocks has gone either up or down by more than 1% on only about 12% of trading days, compared to a historical average of more than 20%.

Stock Market Volatility

Such low volatility isn’t necessarily good or bad, although most investors probably appreciate not having the value of their wealth swing wildly on a day-to-day basis. But low volatility can also trick investors into making bad decisions that damage their long-term performance.

One cause of these bad decisions is regret. Low volatility typically occurs as markets rise: the recent tranquility has occurred in the middle of an almost 40% rise in the S&P 500 index since the start of 2013. When these kinds of bull markets occur, a natural tendency is to wish you had allocated more of your portfolio to stocks.

The effect of regret is compounded by recency bias, the tendency for people to predict what’s going to happen in the future based on what’s happened in the recent past. During periods of low stock market volatility, it can be easy to forget that stocks often move up and down quite a bit (at the nadir of the financial crisis in late 2008 US stocks rose or fell by more than 5% in a single day numerous times).

Regret and recency bias are normal, so it’s not always easy to fight them off. The result can be a low-volatility trap, where calm markets lull you into taking too much risk. The key to avoiding this fate is to honestly assess your willingness and ability to take risk, and then stick to a long-term strategy aligned with that risk tolerance. Sticking to your strategy may not always be easy, but it will increase your chances of achieving your long-term financial goals.