Watch Out During Volatile Bear Markets


Wouldn't it be nice if stock prices smoothly and effortlessly trended upward? Well, let's face reality - they don't. While stock prices do generally move higher over time, there are plenty of bear markets that can knock prices down from 5 percent to 10 percent or more (remember 1987?).

For some investors, the volatility of share prices is too much to handle and they simply invest in bonds or keep their money in savings accounts. Even various government and industry experts have suggested ways of reducing volatility. Some exchanges and brokers have gone so far as to turn off their computers in the midst of a bearish, volatile market, fearful that their computer trading programs will send prices even lower.

But is volatility in and of itself bad? Does it hurt, help or have no effect on the ability of investors to garner returns? Well, that depends, according to two professors at the Sate University of New York at Albany.

They found that in bearish periods of the market, the more stock prices are volatile, the more difficult it is to make excess returns, or returns that are unaccounted for by normal factors and risk. But when there was a bullish market, volatility wasn't an important factor in investors being able to get excess returns.

Professors Hany Shawky and Achla Marathe studied bull and bear markets from 1961 to1990. They found that there is a "highly significant negative relationship between excess stock returns and market volatility during periods of falling market prices."

The professors suggest several reasons for this phenomena. They argue that during bear markets, investors' expectations are irrationally higher than what actual returns will be. Investors are, in effect, blinded by their own optimism and can only really evaluate risk properly during bull markets.

Bottom line: a volatile bear market doesn't preclude investors from making money. It only means they should lower their expectations.

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