Turbulence on the ground doesn’t have to be an earthquake or a tsunami. Consider the tumultuous stretch from August 8 through August 16, 2007, when the Dow Jones Industrial Average plummeted 1,313 points. Like a row of dominoes, PNB Paribas, the largest bank in France, announced it was suspending redemptions on three funds, while central banks around the world injected cash infusions to staunch the hemorrhaging. The European Central Bank loaned out $131 billion—more than it had added the day after September 11, 2001.
And then the investors began panicking.
On that fateful August 16, Scott Mosley called his 15 top clients. Mosley, the owner of Cimarron Capital Consulting, a boutique investment management firm outside Austin, Texas, told his anxious flock that yes, their portfolios had indeed sustained losses, and that he anticipated several more days of volatility. “The crisis appears to be contained,” he told them, and fortunately, they deferred to his judgment.
Whether it makes investors giddy or queasy, volatility is a fact of financial life. Since good planners maintain ongoing conversations with clients in both good times and bad to remind them to expect both upside and downside fluctuations, it certainly helps to know what causes volatility and whether there is any way to ride out the worst of it.
What Creates Volatility?
Because volatility often strikes with little warning, it is easier to identify its sources in retrospect. Inflection points—from a phase of pure growth to one of retrenchment—create uncertainty, as investors are still unsure whether the new phase has yet begun. Each new piece of data is taken as evidence, either by the growth camp or its retrenchment counterpart. “People don’t know how to interpret the direction from the noise, which turns into a tug of war between the two sides,” explains Collin Crownover, the London-based head of currency management for State Street Global Advisors.
A typical example occurred on Oct. 5, 2007, when non-farm payrolls rose by an unexpected 110,000 jobs—with upward revisions to the prior month’s tally. By the time the market closed, the DJIA had vaulted 97 points. Yet it would have been equally possible to construct a logical case that the market should be tanking, since there would be less chance the Federal Reserve might trim interest rates, especially since hourly earnings rose an inflationary 1.4 percent. At that moment, the rate cut that most observers were anticipating suddenly looked less sure. So why was the market going through the roof? Perhaps it was behaving in an illogical way because it was reaching an inflection point.