SOURCE: Disciplined Growth Investors

Disciplined Growth Investors

May 30, 2013 05:00 ET

Disciplined Growth Investors: What Causes Stock Market Volatility?

Benjamin Graham and the Power of Growth Stocks, Part 7 in a Series

MINNEAPOLIS, MN--(Marketwired - May 30, 2013) - "I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."
- Warren Buffett

Volatility is one of the most intimidating characteristics of the stock market, but it also presents the most potent opportunity for advantageous investing for those who understand it and have the patience and fortitude to take advantage of it, according to author Frederick Martin of Disciplined Growth Investors.

Volatility gives shrewd investors the opportunity to take advantage of price swings to buy when prices fall well below the value of the company and sell when they climb well above the company's intrinsic value.

"One of the enduring characteristics of the stock market has been its short-term volatility," Martin writes in his book, "Benjamin Graham and the Power of Growth Stocks" (McGraw-Hill). "We do not choose to waste our analytical efforts to understand why the stock market or individual stocks are priced at the current levels. We do care that this phenomenon repeats itself. This is crucial for those who want to earn returns well above 10 percent."

Short-term volatility will always be part of the market, but to take full advantage of that volatility, it is important to understand that over time, the market always returns to its appropriate level. "In the short run, the market is a voting machine but in the long run it is a weighing machine," said the late Benjamin Graham, who was known as "The Father of Securities Analysis."

Understanding and recognizing the causes of volatility can help you take advantage of these inevitable market swings, as long as you don't allow your emotions to dictate your investment decisions. As investment manager David Dreman put it, "Investors repeatedly jump ship on a good strategy just because it hasn't worked so well lately, and, almost invariably, abandon it at precisely the wrong time."

CAUSES OF VOLATILITY
There are many forces that contribute to stock market volatility, but the most lethal is probably human emotion. "The key ingredient to short-term volatility is human nature and physiology," writes Martin. "We are all imperfect. We all suffer from biases related to our own experiences. We are subject to fear and greed."

Martin maintains that when our portfolio is doing well, a substance known as dopamine is triggered in the brain, creating a euphoric feeling similar to a cocaine high. When our portfolio is slumping, the brain tells us we are in mortal danger. "Consider then that most investors fluctuate between a cocaine-like high and mortal fear!"

That swing in emotions can cause investors to accelerate their buying or selling activity, creating further volatility in the market. But there are also many outside factors that influence the movement of the market:

Transaction-driven brokers. The brokerage industry is largely made up of retail and institutional brokers who make their living through commissions they earn by convincing investors to buy and sell their stocks. Their buy and sell recommendations are prompted by analysts' reports purportedly designed to guide the decision of investors through 'buy' and 'sell' target levels. "The framework used by the 'analysts' who work for the retail brokerage industry is designed to create transactions," says Martin. "Investors should understand that there are at least two major flaws in the average report. First, the report is applying a one-year time horizon to a long-lived asset. This makes little or no sense. Second, the reports base their recommendations on a data point that cannot be forecast with much accuracy: the next 12 months' earnings for a company."

Quarterly reports. Publicly-traded companies are required to file financial reports each quarter. Wall Street eagerly awaits these reports, poised to run up the price or drive it down depending on how the report lines up with analysts' projections. Martin maintains that quarterly reports -- and even annual reports -- are a short-sighted and misguided tool for making a decision on whether to buy or sell a stock. "For astute investors, the importance of these quarterly announcements is not in the heralding of future results," he says. "We have found little correlation between quarterly announcements and long-term stock performance. The real importance is that occasionally the market reaction to these announcements -- especially if negative -- gives astute investors the opportunity to purchase the stock at a price that meets or exceeds their hurdle rate."

Changes in national economic policy. Short-term changes in the monetary police of the "Fed" (Federal Open Market Committee) almost always cause a sharp movement in the market. The market generally moves up when the Fed eases monetary policy and down when the Fed tightens monetary policy. "Investors tend to overreact to these changes," says Martin.

Economic Crises. The market typically reacts negatively to major economic crises -- and the more severe the crisis, the more severe the reaction by investors. Martin believes that these times of economic uncertainty "represent the mother lode for investors who have the courage and knowledge of their individual stocks to take advantage of the crisis." Too often, however, investors let their fears guide their investment decisions, selling as the market drops rather than looking for good opportunities to buy. "Investors are diverted from their fundamental task of analyzing and identifying great investment opportunities when they attempt to analyze the repercussions of an economic crisis," adds Martin. "Since you can't effectively analyze the implications of an economic crisis, why waste your time trying? In times of economic crisis, investors need to focus on their true objective, which is identifying and analyzing great stocks for their portfolio."

Now that you understand the causes of volatility, the real question is will you have the patience and fortitude to take advantage of it? That can be easier said than done. As Graham put it, "The intelligent investor is likely to need considerable will power to keep from following the crowd."

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