Dec 19, 2008
Stock market volatility is currently quite high. Does it make sense for investors to get out of the market until volatility settles down?

EFF: If the current high volatility makes you permanently averse to stock market volatility, and the inevitable variation in market volatility, you should get out. But you shouldn't have been in the stock market in the first place since fluctuations in volatility are the norm. If you eventually want to come back into the market, then you shouldn't leave. Bouncing in and out of the market is risky if your desired long-term asset allocation involves exposure to the market.

The reasoning, in a nutshell, is as follows. The logic of price changes in response to variation in volatility is that the onset of high volatility should be associated with price declines that increase expected returns going forward (to compensate investors for the higher volatility), and the onset of a low volatility period should be associated with price increases that lower expected returns going forward. As a result, if you bounce in and out of the market in response to variation in volatility, you are likely to be in when expected returns are low and out when expected returns are high. Bouncing in and out only makes sense if you can forecast increases and decreases in volatility before they occur, so you can miss the price declines associated with the onset of high volatility and profit from the increases associated with the onset of low profitability. I doubt that anyone is that good at predicting changes in volatility.

KRF: My approach to this issue is a bit different, but I reach the same basic conclusion. I start with the fact that in the short run the number of shares outstanding is fixed. As a result, changes in risk cannot affect the aggregate portfolio of all investors; you cannot reduce your equity position unless someone else is willing to increase his. Changes in risk can, however, affect price. When risk goes up I expect prices to fall and expected returns to rise. And notice that this expected return adjustment is on top of any drop in price caused by lower expected cashflows.

So who should sell? The current market turmoil has taught many investors much more about volatility and their tolerance for risk than they could ever learn from hypothetical examples and thought experiments. Some investors have discovered that big losses hurt more than they expected, while others have concluded they are not as risk averse as they thought. If you are in the first group you might want to sell some equity, but if you are in the second group you probably want to take advantage of your high risk tolerance and buy more. And as Gene said, these should be permanent changes. You might adjust your investments so they are more in line with your actual tastes, but once you do you should plan on sticking with your new portfolio.

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.