Reap the benefits of market volatility

Reap the benefits of market volatility

When stocks are collapsing, worst-case scenarios loom large in investors' minds. On May 6, 1932, after stocks had plummeted 85% from their 1929 high, Dean Witter issued the following memo to its clients:

"There are only two premises which are tenable as to the future. Either we are going to have chaos or else recovery. The former theory is foolish. If chaos ensues, nothing will maintain value; neither bonds nor stocks nor bank deposits nor gold will remain valuable. Real estate will be a worthless asset because titles will be insecure. No policy can be based upon this impossible contingency. Policy must therfore be predicated upon the theory of recovery. The present is not the first depression; it may be the worst, but just as surely as conditions have righted themselves in the past and have gradually readjusted to normal, so this will again occur. The only uncertainty is WHEN it will occur.... I wish to say emphatically that in a few years present prices will appear as ridiculously low as 1929 values appear fantastically high."

Two months later the stock market hit its all time low and rallied strongly. In retrospect, these words reflected great wisdom and sound judgment about the temporary dislocations of stock prices. Yet, at the time they were uttered, investors were so disenchanted with stocks and so filled with doom and gloom that the message fell on deaf ears. Investors often overreact to short-term events and fail to take the long view of the market.

1987 Crash v.s. 1929 Crash

Despite the drama of the October 1987 market collapse, which often has been compared with 1929, there was amazingly little lasting effect on the world economy or even the financial markets. Because this stock market crash did not augur either a further collapse in stock prices or a decline in economic activity, it probably will never attain the notoriety of the crash of 1929. Yet its lesson is perhaps more important: Economic safeguards, such as prompt Federal Reserve action to provide liquidity to the economy and ensure the financial markets, can prevent an economic debacle of the kind that beset our economy during the Great Depression.

This does not mean that the markets are exempt from violent fluctuations. Since the future will always be uncertain, psychology and sentiment often dominate economic fundamentals. As Keynes perceptively stated 60 years ago in The General Theory, "The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." Precarious estimates are subject to sudden change, and prices in free markets will always be volatile. But history has show that investors who are willing to step into the market when others are panicking to leave reap the benefits of market volatility.