Thursday, October 30, 2008

Why Stock Market Jumps Discourage Investing

On Tuesday, Oct. 28, 2008, the stock market jumped about 11% in a single trading session. Good news, yes?

Well, not necessarily. Let's say you had been watching the market fall for most of the preceding week, and decided after the 300 point drop in the Dow Jones Industrial Average on Monday (Oct. 27) to start buying stocks. Your buy orders would have been executed in a rising market on Tuesday. If you have tried to buy mutual fund shares, you would have paid the closing prices for Tuesday (which could have been around 11% higher than the prices you saw Monday evening). The big jump on Tuesday might have been very costly. Most years don't provide investors with an 11% return. Anyone buying stocks or stock-based mutual funds on Tuesday could have "lost" more than a year's gain.

Everyone understands how downward volatility in the stock markets discourages investors. Upward volatility also contains traps. To some degree, you might be able to lessen this risk by buying ETFs, which can be purchased at intraday prices. But in a highly volatile market, getting an ETF order executed at the price you see one moment may be difficult if the market moves abruptly the next moment (which, these days, can easily happen). Consumers would be discouraged if the price of lettuce could rise between the time you took it down from the display case to the time you brought to the cash register. Stock investors can similarly be discouraged by a divergence between the prices they see and the prices they pay.

Much of the volatility may be attributable to big players trading the entire market, using program trading or comparable derivatives contracts. This kind of trading can run right over individual investors (see our blog at There's actually quite a bit of liquidity sitting on the sidelines right now. But the volatility of the market will encourage it to stay on the sidelines. That isn't good. Without a significant inflow of liquidity, the market cannot truly recover.

No federal intervention or bailout can directly reduce stock market volatility. The volatility is a product of the uncertainties about the financial system and the economy, and these uncertainties abound. Perhaps the various federal measures aimed at helping an ever-increasing array of institutions, companies and individuals will eventually lead to calmer markets. Then, again, perhaps the large amounts of still unrecognized losses from the mortgage crisis and the slowing of the world economy will keep the markets jumpy. Until things calm down, though, don't expect a true market recovery.

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