Recent market volatility, triggered by unexpected events such as the Bank of America takeover of Merrill Lynch, the bankruptcy filing by Lehman Brothers, and Federal support for insurer AIG, has led to increased press coverage of events on Wall Street. While this increased coverage is natural, much of it is misguided, thus unhelpful, and may exacerbate investor worries. Consider the following dialogue from a TV news program about the market “chaos” of the last few days:

Reporter: Do you see a bottom to this market?
Guru: No, the bottom is not yet in sight.

Reporter: How long will this market turmoil last?
Guru: It could continue for the next several years.

This sort of thing can really get under an investor’s skin. A naïve listener would naturally conclude that the only prudent thing to do is to sell everything instantly to cash – not money funds, but cash – and park it in a safe place.

The fundamental misconception at the root of the reporter’s questions is that a bottom is never in sight, no matter what the economic conditions – nor, for the same reason, is a top. Remember Alan Greenspan’s prediction of a market top in his famous “irrational exuberance” comment? He only missed it by two years and 2,000 points! We can’t see a bottom ahead of time, whether we are only 1% away from it, or 50%. We don’t know, and cannot know, what the bottom might be until we are well beyond it – by which time we will, by definition, already have seen a good bit of price recovery!

So, the reporter’s first question is ridiculous. The answer is exactly correct: “the bottom is not yet in sight,” is a portentous (and face-saving) way of saying, “I don’t know what’s going to happen.” This of course makes the reporter’s second question pointless. The guru answers (as gurus so often do) with words that say nothing; for any statement expressed in the conditional tense is worthless as a guide, is devoid of information – after all, we “could” discover cold fusion, we “could” be hit with a nuclear bomb, we “could” be destroyed by avian flu, etc. etc.

If your planning horizon is short term – i.e., you need all the money in your portfolio in the next one or two years – then you should get out of the market (indeed, you should never have been in the market). But when you take such a step, when in effect you ask for protection against downside risk, then whether you realize it or not, you are simultaneously asking for protection against upside returns. Thus if your planning horizon is long term – e.g., a lifetime retirement income objective – then you should welcome market volatility, because it is the engine that drives expected returns above the risk free rate.

Return is a random variable that no one can predict, making it impossible to control. Risk by contrast is a variable that can be assigned a probability measure, making it amenable to some degree of control. SCLC portfolios are designed with the client’s risk tolerance in mind. If a portfolio remains within the risk bounds set by the Investment Policy Statement (IPS), no change of policy – such as exiting a bear market – should be taken, lest pursuit of long term objectives be imperiled.

Periods of great market volatility such as we have lately experienced can naturally give rise to feelings of doubt and anxiety. Your Portfolio’s IPS is designed for just such times as these. It is intended precisely to set a policy – that is, to prevent reacting out of panic when markets turn suddenly bearish, or out of greed when they seem imperviously bullish. Not to put too fine a point on it, the IPS is designed to prevent the investor from selling low and buying high.

Without making any prognostications about the future course of the markets – anything “could” happen – we would note simply that, in our monitoring of client portfolios even through such episodes as the dot.com crash of 2000, we have found again and again that their performance fell well within the statistically expected range of risk and reward modeled in their IPS. In other words, such periods of volatility as now try our patience are to be expected – are not at all abnormal.

Our upcoming issue of Investment Quarterly will focus on volatility, specifically with respect to bear markets. If in the meantime you should wish to discuss the events of the last days, we hope you will not hesitate to call.