With or without reason, stock prices fluctuate. This behavior is known as volatility, and it makes equity investment risky in the minds of the masses, specifically when the price falls after one buys the stock. Even though disliked by most market participants, volatility is and will remain an integral feature of equity investment. Since eliminating volatility is not feasible, one needs a robust thinking framework to understand volatility’s true nature and devise a good action plan. The perspective provided by such a framework will make one start liking and benefiting from times when volatility unfolds.

When faced with volatility, the mind is filled with emotions such as hope and fear while contemplating financial matters. Hence, the thinking framework must be capable of providing insights into hope and fear to demystify volatility. A 2×2 matrix discussed below provides the easy-to-comprehend framework. In each category on this matrix, the mind assesses and selects competing choices using loss aversion tendency, which means that losses are weighted at least 2x that of gains.

Let’s imagine a 2×2 matrix. Matrix’s Y-axis represents probability ranging from possibility (+Y) to certainty (-Y), and the X-axis represents net result ranging from gain (+X) to loss (-X), resulting in four categories that imply an individual’s mental state under different circumstances: the possibility of a gain (PoG), the possibility of a loss (PoL), the certainty of a loss (CoL), and the certainty of a gain (CoG). Among these four categories, two (PoG and CoL) evoke hope with risk-seeking behavior, and others (PoL and CoG) evoke fear with risk-averse behavior.

Let’s delve deeper into each of them.

1. PoG (the possibility of a gain) is apparent when someone contemplates buying a lottery ticket. The probability of winning is negligible, yet people exhibit risk-seeking behavior and buy the ticket because the hope of a big payoff provides immense pleasure to the mind. Luckily, people bet an insignificant amount compared to their net worth. In the investing world, it is akin to buying the stocks of questionable businesses. It’s best to avoid investments falling in this zone as these are long shots due to a lower probability of winning, which results in a lower conviction that limits the bet size. A smaller bet size can’t enhance overall portfolio returns even if it turns favorable.
2. CoL (the certainty of a loss) is noticeable when someone contemplates selling a stock position that is in loss. The choice is between booking a confirmed loss now or keeping hope alive to break even with time. Selling converts a notional loss to reality. Selling at a loss is repulsive to the mind as it acknowledges one’s mistake. Hoping to break even sooner, an investor exhibits risk-seeking behavior and buys more at the prevailing price. The sunk cost fallacy prevails in this category. A bad situation could quickly turn worse. Instead of deciding to buy due to the fall in the price compared to the original buy price, an investor should be mindful and revisit the original thesis to decide further course of action. Either hope to break even by buying more with a solid rationale or accept the mistake and close the position without regret or disappointment.
3. PoL (the possibility of a loss) is observable when someone contemplates buying insurance for a car. Although the probability of an accident and a huge loss is negligible, people exhibit risk-averse behavior. They choose mental peace and purchase insurance to eliminate the fear of a huge loss. This category is observable in investing when someone needs to hedge a portfolio using options to mitigate equity drawdowns, leading to continuous expenditure and management. I think it’s best managed by avoiding leverage and keeping a long-term investment horizon.
4. CoG (the certainty of a gain) is noticeable when someone contemplates selling a profitable position. Fear of giving up certain gains motivates the mind to sell off the profitable position instead of directing the focus on the future potential of the stock. By ensuring sufficient diversification and buying proven and sustainable businesses, an investor can transform his behavior from risk-averse to risk-seeking. Doing so will ensure that one does not sell the winning positions under fear and can create serious wealth with equities for oneself and loved ones.

The 2×2 matrix provides insights into the constant interaction among volatility, hope, fear, and investor behavior. This mental model quells my fear of equity investment and makes me understand volatility as a friend who intends to provide immense benefit. I hope it does add another perspective to your thinking as well.