11 Nov 2014

Volatility is an occasional yet inevitable feature of equity markets. Corrections are to be expected over the course of a long bull market; indeed, they are often healthy pauses that set the foundations for the next upswing. However, common behavioural biases such as herding and loss aversion can encourage many investors to react emotionally and make knee-jerk investment choices that can derail the creation of long-term portfolio value.

During any period of volatility and market weakness, a good many investors will feel a powerful urge to do as others are doing and reduce their allocations to stock markets. By and large, this tends to be a poor move – particularly if it is a mid-cycle correction in a bull market as many commentators have characterised the recent volatility in stock markets. In this case, it’s a poor move because it crystallises what may be a temporary loss yet risks missing the benefit of any rebound or recovery in share prices. Investors are better advised to resist the emotional temptation to sell during weakness or to try and time the market, since missing out on relief rallies can seriously impair long-term returns. Indeed, many successful investors use indiscriminate market volatility to buy quality stocks at discounts during sentiment-driven sell-offs.

In his seminal work, The Intelligent Investor (1949), Benjamin Graham offered the analogy of ‘Mr Market’ to show how volatility can be an investor’s best friend or their worst enemy. Mr Market is an imaginary business partner, who on each day offers to buy and sell shares with you. Some days he will be wildly optimistic about certain businesses and quote very high prices. Other days he will become a manic-depressive, and ready to offload quality shares at bargain-basement levels.

Graham’s point was that you shouldn’t let Mr Market’s oscillating views dictate your actions. On occasions, the irrationality of the market can mean substantial discounts in stock prices relative to their intrinsic worth. Regular saving throughout the business and investment cycles inclusive of periods of volatility – known as cost averaging – is a tried-and-tested way of taking advantage of such periods. Alternatively, active, tactical investors can also sniff out bargains that have been unfairly discounted by the market.

Graham’s observations on Mr Market were ahead of their time and laid some of the groundwork for the development of the burgeoning field of behavioural finance a few decades later. Using tools borrowed from the field of psychology, behavioural theorists such as Daniel Kahneman showed beyond doubt that investors are far from rational in practice. In fact, when confronted by complexity and uncertainty, experiments consistently show that investors revert to using rules of thumb or decision-making shortcuts.

Psychology and neuroscience research suggests our brains have two cognitive decision-making systems: fast-thinking System 1 (also known as the x-system from reflexive) and the slow-thinking System 2 (also known as the c-system from reflective).

System 1 is automatic and often unconscious; it responds to the environment as quickly as possible, especially in times of perceived danger. It is the older part of our brain in evolutionary terms that controls the fight or flight response. System 2 is engaged for challenging problems where calculation and deliberation is required. It is the more recent part of our brain in evolutionary terms.

The big problem is that investors tend to revert to the automatic, emotionally-influenced System 1 during times of stress and uncertainty, rather than use the deliberative and rational System 2.

There are two principal behavioural biases that kick in during times of market stress: herding and loss aversion.

The urge to do as others are doing is a particularly powerful bias in human behaviour that has aided social development. It is not always helpful in investing, however. One of the most serious investment implications of following the herd is that investors end up buying when prices are high and selling when prices are low. This is known as ‘chasing the market’ and it is a terrible investment strategy. In reality, it’s better to do the opposite; buy when others are fearful and prices are low and sell when other are greedy and prices are high. The best investors like Sir John Templeton have always known that in order to beat the market you have to do something different from the herd. The problem is that going against the herd feels uncomfortable for most of us – we have to fight our emotions.

Loss aversion is one of the most significant behavioural biases affecting investment. Experiments show that people take the safe option in gambles that involve gains, but actually take the risky option in gambles that involve potential losses. This is due to a deep-seated human behavioural bias to avoid losses (financial or emotional). Experiments have shown we feel the pain of a loss about twice as deeply as the happiness from a gain.

During times of uncertainty, when markets are going down and everyone appears to be selling, these two behavioural biases can work in combination to produce a pronounced emotional effect on many investors. Together, they can cause investors to capitulate (System 1 is making the decision) and sell at the wrong time for the wrong reasons.

Stock prices are ultimately driven by fundamentals like corporate earnings, not short-term sentiment. Over long periods of time, stocks have significantly outperformed other types of investments and have readily outpaced inflation. While stock markets have historically been more volatile than other asset classes, long-term investors have been rewarded with higher returns to compensate for this additional volatility.

This is why investors should not let short-term volatility ruin their long-term investment plans. Instead, it is worth recognising that behavioural biases are at play during volatile times, supporting famed investor Graham’s observation that investors’ worst enemies are themselves. Meanwhile, attempting to trade in and out of the market during such periods is usually a recipe for higher trading costs and lower cumulative returns.

The nature of stock market volatility means that it makes sense for many investors to follow a regular investment plan, investing a certain amount of money each month or quarter and periodically reviewing the overall portfolio. This strategy of monthly cost-averaging allows investors to lower the average cost of stock purchases. However, critically, it also helps to take the emotion out of investing, meaning investors are less likely to be panicked into misguided buying and selling decisions, based on Mr Market’s mood swings.

A great read published in Fidelity Insights.

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