Good Volatility, Bad Volatility, and Why You Shouldn’t Panic

In the market, there are ups and downs. There is good volatility, in which the market is up, and then there is bad volatility, in which the market is down. Anyone who so much as dabbles in investing knows this to be true. I could not make a statement about investing more obvious than this. Nevertheless, when we reach that tipping point and the market suddenly changes, few of us rarely behave as if it is a normal experience. Instead, we tend to panic.

In 2007, behavioral psychologists conducted a lengthy study in which they measured the expectations of people in romantic relationships. At the beginning of the study, they asked participants how they expected they would feel if they were to break up with their partners. After 38 weeks, the participants who had experienced breakups were then asked how they actually felt. What the researchers found was that there was a vast disparity between how those in relationships thought they would feel after a break-up and how they actually ended up feeling. While most participants thought they would be devastated after the relationship ended, they had in actuality more or less gotten over it.

This study has been replicated in all sorts of contexts. It’s what psychologists call “hedonic adaptation,” or our exceptional ability to get used to any situation. The same results have been observed with people predicting how they would feel if their favorite football teams lost a big game, how they would feel if their favored politician lost an election, and how they would feel if they were to receive negative feedback about performance at work. No matter how bad the situation is in life, we have the capability of adapting and moving on.

So, why am I talking about this research? What does it have to do with investing? Well, since March of 2009, we have experienced a great run in the market. We have had consistently good volatility and the market has continued to go up. I think it’s time that we start preparing ourselves for a downward trend. What goes up must come down and it seems that we’re about to hit the downward slope of the market cycle.

When the market begins to decline, it is important not to panic. It is important to adapt. Just like the experiments with the behavioral psychologists, we may think that it would be devastating to our portfolios to experience a downturn. But, if we can keep our wits and stay patient through the natural cycle, we probably will not be so devastated as we may think. We will adapt. The market will rebound and we will experience good volatility again.

The absolutely worst decisions are made in states of emotional distress. Did you happen to read “Romeo and Juliet” in high school? Don’t panic when the market naturally fluctuates. Don’t throw up your arms in defeat when the inevitable decline comes. Hold your ground. Keep your reason. Don’t let your emotions get the best of you. It’s never quite as bad as you think it will be.