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Financial markets are often driven by fear and greed.
Research suggests that investors tend to become overly optimistic about good news, and excessively despondent when news is negative. This phenomenon is exacerbated by our connectedness through social media in the information age. As such, news travels fast, and quite often, global events are sensationalised.
The result is periods of heightened emotional and irrational decision-making leading to market volatility, featuring high peaks and low troughs, which can spark the temptation for investors to follow prevailing trends. This distractive risk should be avoided, as studies show it can compromise returns for medium and long-term investors.
The graph below shows that periods of Extreme Greed (excitement, thrill & euphoria) produce the highest level of financial risk for investors, as there is an expectation that markets will keep rising. Unfortunately, it is very difficult to know when the bull markets have peaked, and a decline is imminent.
The best time for investing is at the bottom of a bear market, during periods of Extreme Fear (panic, despondency & desperation). This is when assets are generally undervalued. However, much like predicting the top, finding the bottom of a bear market is notoriously tricky, too.
Availability Bias
In volatile markets where emotions run high, it is easy for investors to succumb to availability bias. This refers to the tendency to use only the most available information to make decisions. In the context of the conflict in Ukraine, comprehensive media coverage keeps this negative event at the top of our minds. For investors, this provokes anxiety, nervousness, and a desire to make irrational changes to their selected investment strategy.
Ultimately, availability bias can cause investors to lose focus of their longer-term investment strategy, financial goals and the reasons they hold certain assets in their existing investment strategy.
Historical Example:
The financial crisis of 2008 was one of the biggest economic meltdowns in the U.S. since the Great Depression and lasted for 18 months. It was a traumatic event that was felt globally, and many lives were changed forever.
From 29 August 2008 to 9 March 2009 the MSCI World Index declined by 47% and this decline propelled the Wall Street Fear VIX fear gauge to an all-time high. From an emotional standpoint, most global investors panicked due to the amount of fear being experienced in the market. However, those who saw an opportunity or resisted the urge to sell their existing portfolios and convert to cash (money market) benefitted from the MSCI World Index recovering within 20 months to 11 November 2010 and returning 23% p.a. over the subsequent 5-year period.
MSCI World Index ($) – Start of market collapse to recovery – 29 August 2008 to 11 November 2010
MSCI World Index ($) 5 Year Return from bottom of market collapse – 9 March 2009 to 9 March 2014
Investing with purpose
There are several ways to insulate oneself from Distractive risk and Availability bias.
Firstly, try to view current trends in the context of your holistic financial plan and risk profile, and to speak to one of our Client Portfolio Managers if you need more clarity or guidance. Secondly, avoid letting short-term trends inform your long-term goals. Remember your reasons for investing in the first place.
Lastly, in the words of the great investor Warren Buffet, “be fearful when others are greedy, and greedy when others are fearful.” In times of volatility, opportunities are at their most prevalent.