How to Handle Market Volatility: Understanding the Fear and Greed Cycle
When you invest in the stock market, there's one thing you'll inevitably face: volatility. Some days the market surges, other days it plunges. In the face of this volatility, many investors panic or make poor decisions.
Today, I'll help you understand the true nature of market volatility and show you how to respond wisely.
📉 Why Do Markets Go Down?
To understand why markets decline, we first need to understand how stock prices are determined.
Back to the Lemonade Stand Example
Imagine a lemonade stand that generates $1,000 in annual profit. We agreed to buy it for $10,000, expecting a 10% return. This represents a P/E ratio of 10.
But here's the problem: This P/E multiple doesn't stay constant. It bounces around wildly based on investors' moods and emotions.
📰 One News Article Can Cut Value in Half
Imagine this scenario. You're about to buy the lemonade stand for $10,000 when you see this headline:
"Amazon Acquires Lemonade Company, Plans to Offer Free Lemonade to All Prime Members"
Would you still want to pay $10,000?
When Fear Takes Over
- A giant competitor (Amazon) enters the market
- Uncertainty about future profits increases
- 10% return is not enough to compensate for this risk
- "I need at least a 20% return"
- P/E drops from 10 to 5
- Stand value: $10,000 → $5,000
One news article cut the value in half.
📈 Conversely, Value Can Double
Now imagine the opposite headline:
"Rhode Island Outlaws New Lemonade Stands. Existing Businesses Grandfathered In"
The government essentially created a monopoly. No new competitors.
When Greed Takes Over
- Competition worries disappear
- Confidence in future profits increases
- "10% return is too high, 5% is fine"
- P/E rises from 10 to 20
- Stand value: $10,000 → $20,000
One news article doubled the value.
🎭 The Fear and Greed Cycle
What changed in both scenarios? The business was exactly the same. What changed was investor perception.
| Situation | Investor Emotion | P/E Change | Price Change |
|---|---|---|---|
| Bad news | Fear 😱 | Declines | Declines |
| Good news | Greed 🤑 | Expands | Increases |
This is a predictable, repeating pattern:
- Fear → Market prices decline → Eventually turns to greed
- Greed → Market prices rise → Eventually turns to fear
This cycle repeats again and again.
📊 Major Market Crashes in the Last 100 Years
Over the past century, we've experienced numerous market crashes:
| Year | Event |
|---|---|
| 1929 | Great Depression |
| 1940s | World War II |
| 1970s | Oil Crisis |
| 1980s | Inflation Crisis |
| 1987 | Black Monday |
| 2000 | Dot-com Bubble |
| 2008 | Financial Crisis |
| 2020 | COVID-19 Crash |
In every case, something was going wrong in the world, causing months or years of dramatic price declines.
📈 Declines Are "Normal"
Here's the surprising truth: Declines are perfectly normal.
Annual Decline Frequency
According to JP Asset Management's chart showing S&P 500 annual returns (black line) and intra-year maximum decline (red dot):
- Even in years with big gains, 10%+ declines are common
- This isn't the exception—it's the rule
Decline Frequency Statistics (Since 1928)
| Decline Size | Frequency |
|---|---|
| 5% or more | 95% of years |
| 10% or more | About once per year |
| 20% or more | About once every 4 years |
| 30% or more | About once per decade |
| 50% or more | A few times per century |
🔄 Why Do Markets Recover?
Declines are easy to understand—there's always something big happening in the world. But why do markets recover?
1️⃣ Corporate Innovation
During crises, companies adapt, develop new products and services, and eliminate dying divisions.
2️⃣ Corporate Consolidation
When weak companies die or struggle, strong companies acquire those businesses or customers.
3️⃣ Government Support
Governments provide stimulus, and central banks lower rates to stimulate borrowing and growth.
4️⃣ Population Growth
Even during declines, population continues to grow, naturally increasing demand for goods and services.
5️⃣ Earnings Recovery
Corporate earnings that declined during downturns eventually bottom out and start recovering.
6️⃣ Stock Buybacks and Dividends
Even in tough times, profitable companies buy back stock and pay dividends, supporting share prices.
7️⃣ Investor Confidence Returns
Once prices start rising, investor confidence returns, which raises prices more, bringing even more confidence.
📊 The Long-Term Trend of US GDP
Look at US GDP over the last 80 years. The long-term trend is up and to the right. The gray bar periods represent extreme economic stress, but look at the long-term trend. Even during those stressful periods, GDP continued to grow.
This is why markets recover.
💡 The Wise Investor's Response: Be Like Aaron
Remember Aaron from the beginning of the video? Aaron invested a fixed amount every month regardless of what was happening in the news.
- $400/month consistently in good times and bad
- Bought at market tops AND market bottoms
- Consistent investing = dollar-cost averaging
📜 Benjamin Graham's Famous Quote
Warren Buffett's mentor said:
"In the short term, the market is a voting machine—driven by popularity. But in the long term, the market is a weighing machine—it weighs the profitability of corporations."
This is the key. Short-term, emotions drive the market. Long-term, actual corporate profits drive the market.
❌ Stock Market Myths Debunked
Myth 1: "Investing is only for the wealthy"
❌ Wrong. Anyone can start today. Investing isn't for the wealthy—it's how ordinary people become wealthy.
Myth 2: "You need to time the market"
❌ Wrong. Consistent investing in good times and bad outperforms market timing.
Myth 3: "Stocks are risky"
❌ Partially true. Short-term, yes. But long-term, stocks are extremely safe—the only asset that consistently beats inflation.
Myth 4: "Bonds are safer than stocks"
❌ Wrong. Bonds are less volatile, but long-term, stocks are actually safer.
Myth 5: "Sell when the market drops"
❌ Wrong. Markets recover over time. Selling locks in losses and misses the recovery.
Myth 6: "You need a financial advisor"
❌ Wrong. You can manage your own money. No one cares about your money more than you.
Myth 7: "You need to watch the market"
❌ Wrong. Buy and hold index funds long-term, and you don't need to worry about short-term prices.
⚠️ Common Investing Mistakes
Mistake 1: Trying to Time the Market
It's extremely difficult. Just invest consistently every month.
Mistake 2: Not Diversifying
Don't just buy a handful of tech stocks from Reddit. Diversify your assets.
Mistake 3: Selling When Markets Get Volatile
That's exactly the wrong strategy. Selling during volatility only locks in your losses.
Mistake 4: Ignoring Fees
Don't ignore fees. Keep them as low as possible.
Mistake 5: Failing to Rebalance
Once a year or every three years, make sure your portfolio matches your desired risk profile.
💰 When to Sell Stocks
Selling is much harder than buying. But there are valid reasons to sell:
1️⃣ When the Investment Thesis Changes
Technological disruption, management changes, product popularity decline, margin deterioration
2️⃣ Emotional Reasons
If your portfolio is unbalanced, you can't sleep at night, or you're checking prices every minute
3️⃣ Tax Purposes
Selling losing investments can provide tax benefits
4️⃣ Life Priority Changes
Home purchase, kids' college, marriage, divorce—life changes
🏦 Taxes When Selling
Taxable Accounts
- Short-term gains (held < 1 year): Higher tax rate
- Long-term gains (held > 1 year): Lower tax rate
- Losses: Deductible up to $3,000/year from income
401k
- No immediate taxes on selling
- Only taxed on withdrawal
Traditional IRA
- Tax-deferred
- Taxed only when withdrawing
Roth IRA
- After-tax contributions
- Tax-free withdrawals if rules are followed
✨ Key Takeaways
How to respond to volatility as an investor is simple:
- Accept that declines are normal
- Understand the fear and greed cycle
- Invest consistently like Aaron
- Maintain a long-term perspective
- Don't react to short-term news
As Benjamin Graham said, short-term the market is a voting machine, but long-term it's a weighing machine. Time is on your side. 🌟