Why Risky Markets Are More Predictable

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Today, I’ll attempt to answer two questions.

One, why are risky market conditions actually more predictable in nature? And two, how do our moods affect our investment returns?

High risk means high predictability

To answer the first question, you need to know why prices move around in the first place.

Market prices move up and down due to trading activities. There are buyers and sellers in the market who transact on a daily basis. This changes the demand and supply for securities, leading to changes in prices.

The real question here is not the mechanics of demand and supply, but rather why people behave in such an uncoordinated way. Investors do not act in unison because everyone has a different set of circumstances. We all have distinct payoff expectations, risk tolerance levels, beliefs, strategies, timing, capital levels and many other distinguishing factors.

This means everyone trades very differently, at different times, and at varying volumes. The result is a complex, almost random system.

For example, last week we went through ‘Brexit’, which saw the British people vote to leave the European Union. This event had already rattled global markets in the two weeks leading up to the vote. We have seen fluctuations in commodity prices, currencies and stock markets. And there was much more volatility in the aftermath of the referendum.

More so than any public vote, market reactions are always more predictable. That may sound counterintuitive; you may think the unpredictability of a referendum should generate more unpredictable behaviour. The truth is that the originally complex (scattered) actions and motives of investors become more uniform during a publicly-acknowledged event such as Brexit.

Normally, investors go about their business hunting for bargains in the market, or managing their trading positions. But, with Brexit, we were all focused on this event with a binary expectation — ‘Leave’ or ‘Stay’.

Just like the Global Financial Crisis, when fear takes over the market, everybody focuses on risk and exiting positions. These events make our aggregate social behaviours less chaotic, and more uniform. In other words, the balance between the bull force and the bear force, which in normal market conditions would result in a less volatile market, tipped over during Brexit.

Which is why we saw big ‘swings’ in the market on Friday. And why they’ll continue this week.

Being emotional can be good for returns

Now, for the second question: How do our moods affect our investment returns?

I just described why a market behaves in the way that it does. But that’s more of a social phenomenon. Now we will pay attention to a more ‘micro’ element of the market — individual emotion.

I came across an academic journal entry published in the Federal Reserve Bank of Atlanta Economic Review. The entry talks about market psychology and investor emotion. It found that, while emotions have a big influence on financial behaviour, they do not meaningfully ‘contaminate’ judgement.

The writer argues that emotion is a positive force to investment decision making if its distracting properties are kept in check.

What you may not know is that the ‘groundwork’ in modern economics literature is based on unrealistic rules. Economists believe that individuals in a market have perfectly rational minds, and perform perfectly rational actions. Now, you must be thinking that economists are completely irrational to believe that — and you’d be right. There is no way of divorcing human cognitive decision making from our core emotional elements. Maybe an artificial intelligence can, but we humans surely cannot!

In another article, this one from the Journal of Economics and Social Research, the writer (Yilmaz Bayar) measures the effects of the Global Financial Crisis on the behaviour of individual investors.

He found that the crisis negatively affected investors’ risk perception of financial instruments; it lowered the general risk tolerance level towards stock investing; it lowered investor confidence; it altered trading behaviour; and it made everybody blame someone else (advisors, the government, rating agencies, etc.).

That gives you an idea of how a crisis can affect emotions, altering actual investing and trading behaviours.

Then there was the study from Carnegie Mellon University in Pittsburgh, Pennsylvania. It showed that people are more likely to follow advisors with more confidence. People are willing to overlook poor track records to choose more confident advisors. That is another interesting way of showing how emotions can affect investor decision making, in this case their choice of advisors. Although, following a confident advisor with a poor track record is unlikely to consistently deliver you better returns!

Going back to the Federal Reserve Bank of Atlanta entry, here are some of its interesting findings:

  • There is a direct correlation between market events and psychological characteristics of traders.
  • Emotions help to clarify decision making when there is a lack of time, or too much information.
  • Positive feelings allow quicker access to information in the brain; it promotes creativity and helps problem solving.
  • People are more optimistic on a sunny day, and are more inclined to buy stocks.
  • Risk aversion is correlated with anxiety and depression.
  • Investors prolong getting out of a losing trade in order to avoid recognising losses, in an attempt to avoid feeling regret.
  • Investors get out of trades too early due to a need to realise a feeling of pride.
  • The feeling of like (good impression) or dislike (bad impression) of market conditions (or a particular stock) can directly affect investors’ decisions.

Currently, there are not enough solid results from behavioural research to topple the ‘rational’ school of economic thought. However, it is clear that the rational school has unrealistic assumptions for the market.

What should you do?

Behavioural research gives us some very powerful knowledge on how and why we do certain things. You can use this knowledge to better understand and regulate your own behaviour. You can use this knowledge to see opportunities in the market.

‘Don’t let emotions cloud your judgement’ is right. Yet emotions can be supportive of returns when you can understand and take advantage of it.

Regards,

Ken Wangdong,
Editor, Emerging Trends Trader

Editor’s Note: This article was originally published in Emerging Trends Trader.

The Daily Reckoning
The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.
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