Volatility: The Silver Lining Playbook – Part 3
Last week I shared the first four of the top ten reasons I believe we need to reframe our view on volatility, A.K.A. my “volatility silver lining playbook.” This week we are going to look at three more reasons why volatility is necessary for the markets.
Let’s see what we’ve got!
Volatility is a signal to policymakers
The market is good at being a messenger, not only to corporate America but also to our government’s policymakers. Markets are like a real-time barometer on investor sentiment on monetary policy, fiscal policy, government regulation, and political legislation.
If you think about it, policymakers don’t get feedback from us instantly, but they sure can tell what we think if they pass legislation and the market sinks or soars. When we believe policymakers have made mistakes that create economic issues, it is common for Americans to sell their risky assets and move into more conservative options. Washington then has two options: 1) defend their decisions, or 2) change course.
A perfect example of this is when the Fed made policy changes last March in response to the coronavirus outbreak, and markets began to climb back up to previous levels.
Volatility keeps excess in check
When sectors get bloated financial markets can act as checks and balances, albeit unpleasant ones. In fact, markets are a pretty dependable predictor of economic recessions, and they will tip us off with things like excess in the housing market, for example.
What happens is that excess builds up for a while when investors believe risk is at low levels. This will go on for a time, and then before you know it, we’ve got a bubble that usually bursts. So, while volatility can often signal that we’re about to explode, these periods of volatility are also a way of “right-sizing” the markets. They can actually stop bubbles from forming in the first place, and they can prevent bubbles that do burst from being as destructive as they could be.
Volatility stress-tests financial technology
Technology seems to be advancing at a breakneck pace for the last decade. New financial technologies are developed all the time; one of the “latest and greatest” is Robo advisors. The issue with Robo advisors is that the concept hasn’t been tested since it came out.
Just because an investment strategy makes you money during a calm bull market doesn’t mean it’s a successful strategy. Making money in those types of markets is easy; it is not losing money when things get crazy that counts. This is where Robo advisors fall short because this type of technology can be one-dimensional.
When the “you know what” hits the fan and we are in a time of extreme volatility, the strategies and technologies worth their salt will be validated and increase investor confidence because they are viable long-term solutions. In my opinion, Robo advisors aren’t one of them.
We will wrap up next week with the final three ways volatility can be a silver lining. I hope you will join me.
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Until next time...