Personal Finance: Volatility demands disciplined investment

Personal Finance: Volatility demands disciplined investment

March 23rd, 2011 Chris Hopkins in Business Diary

Chris Hopkins

Photo by Contributed Photo/Times Free Press.

The world is a turbulent place, and the current level of uncertainty is especially high.

The stunning events of the past two months evoke grief for the stricken, hope for the downtrodden and apprehension regarding the ultimate outcome of so many geopolitical and environmental challenges.

However, for long-term investors, it is useful to reflect upon the motive forces of global markets in order to place these proximate crises in perspective.

Market volatility has risen appropriately in response to the unrest in the Middle East and North Africa, and has accelerated with the news of the Japanese earthquake and tsunami. With the unfolding nuclear crisis in Sendai and military strikes on Libya, short-term swings in stock prices are further amplified in response to hourly news flow.

For many of us, it is difficult to keep a longer-term perspective and maintain a steady course with our investment plan. Yet it is crucial to do so and to avoid the temptation to overreact to temporal disturbances that may have relatively small long-run consequences.

Benjamin Graham and David Dodd, in their seminal 1934 book on value investing, made a useful distinction that continues to prevail today.

In the short run, they likened the stock market to a voting machine that tallies up the ballots cast by traders, anointing winners and demoting losers in the daily ebb and flow of events.

For most individual investors, trying to outguess the variegated stream of random developments is a loser's game; hence the need for a more structured and patient approach.

In the long run, Graham and Dodd compared the market to a weighing machine. In this analogy, all relevant information over a reasonable time horizon is collected, digested and metabolized by the market and ultimately shows up on the scale.

While the chocolate cake I ate last night spiked my blood sugar this morning, the effect of that one indulgence will recede into insignificance over time if my diet is otherwise moderate.

For investors, it is the weighing machine that matters.

Numerous studies of post-disaster stock price behavior repeatedly confirm that the market impact of transient destructive events diminishes rapidly over time, and that the fundamental factors at work prior to the episode quickly reclaim their dominant role in market direction.

Maintaining a disciplined investment plan for the long run and sticking to the plan is especially critical during tumultuous times.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Chris Hopkins is vice president of investments and a certified financial analyst for Barnett & Co., Inc. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com