Many investors have a tendency to overreact to dramatic and unexpected events, like short-term falls in financial markets. Being aware of, and understanding, how cognitive biases might affect you can help lead to better long-term investment decisions.
This year got off to a bumpy start, with market volatility spiking in response to surprisingly high inflation, and a potentially more hawkish monetary policy response. There is nervousness about how economies might fare as interest rates rise. Investors were also hit by a sharp correction in many tech stocks, as investors switched into value stocks from growth ones, and large moves in response to earnings.
Adding to the “risk-off” sentiment are mounting geopolitical risks, with the possibility of, and now the realisation of, armed conflict between Russia and Ukraine causing large swings in indices in recent weeks. Against this backdrop, there are also the challenges of the coronavirus pandemic, which continues to linger (albeit with reduced severity).
In times of uncertainty, unexpected and dramatic events can lead to violent market moves. Sometimes they are short-lived, and the market will bounce shortly after. As such, markets frequently overreact to news, at least initially. For investors, having an awareness of these reactions and triggers – which seem to run counter to the efficient market hypothesis – can help them to navigate such periods better.
Examining individual investors
According to models of rational decision-making, individuals make judgements on the likelihood of events occurring based on a conditional probability rule, which is updated given new or additional evidence.
When considering purchasing an individual stock, forming a view on the probability of making a gain, based on past performance, and you receive news that affects that probability, your beliefs should be updated with the fresh information, applying an appropriate weight to it.
However, research in experimental psychology suggests that most people overreact to unexpected and dramatic news events. In revising their beliefs, individuals tend to overweight recent information and underweight prior data. This violates a basic statistical principle - that extremeness of news should be moderated by considerations of probability; people may make investment choices based on small amounts of data, ignoring base rate information.
One reason for this is the availability heuristic; a mental rule of thumb that leads us to assign more weight to events that are easier to recall. The implication for investors is that in response to unexpected and dramatic news events, such as a geopolitical act of aggression, they may assign more weight to the event and its consequences versus history than they should.
The market is made up of these investors
The theory of efficient markets suggests that mispricings caused by individual investor biases should be arbitraged away. However, market sentiment is the sum of the mood of individual investors, and therefore, an individual’s overreaction may at times be seen in the overall market, at least in the short term.
In a seminal study of market efficiency, researchers examined the question of whether the market overreacts, and found that the empirical evidence based on monthly investment returns data was consistent with the hypothesis that the market does overreact. The effect was found to be asymmetric – it was larger for negative reactions than positive.
Academic literature opines that stock price reversals might be due to short-term overreactions to news, waves of unjustified optimism or pessimism about future earnings, and fear and normatively excessive risk premia, to name a few.
Sentiment can become extreme
An important aspect in this discussion is sentiment, or the attitude of investors toward a particular security or market.
In the same way as the experience that extreme emotions can affect how we see the world, so too can that be said of the market. Sentiment often becomes excessively bearish or bullish, and can prompt knee-jerk responses from investors.
Conversely, if sentiment is very bearish, some may pay too much attention to negative news, and not enough to positive events. Those that take a “buy the dip” approach to investing, may see this as an opportunity. Alternatively, sentiment can be so bearish that investors cling to any positive news, and even overreact to it.
Additionally, as previous bubbles and subsequent crashes have shown, these episodes can be self-fulfilling, highlighting the role of expectations in market dynamics. February’s Market Perspectives showed that US consumer sentiment was at its lowest level since the start of the pandemic, and its lowest in a decade. A month on, it continues to weaken. Previous troughs in sentiment have followed major geopolitical shocks, which is a possibility depending on how the situation in Ukraine evolves.
As we have previously discussed, stocks do rise most of the time, and are more likely to rise if there has just been a sell-off, making staying invested a better strategy than attempting to time the market.
Overreaction is not limited to one-off events, it is also a feature of market momentum. A study examining the difference between implied volatility and realised volatility of a stock following sharp price movements found that following a fall of at least 10%, implied volatility of puts exceeded the ex-post realised volatility of the underlying stock by 25.3%. For a price drop of at least 20%, the volatility difference was 27.5%.
One explanation given for the difference is that put options become overpriced following extreme recent price drops, due to the demand generated by panicking investors. Following price rises, call options became similarly overpriced. The rationale here is that investors become overly excited following sharp price rises and buy calls to take advantage of anticipated further rises.
Are your own reactions proportionate?
For long-term investors, it is important to respond to market events in a measured and proportionate way. Reacting to short-term market news may deviate from long-term goals, and is a risk to be cognisant of.
Below are some questions that may be worth considering when faced with unsettling news:
- While dramatic, is the news fundamentally significant to investors?
- Is the event likely to have a long-lasting impact on my portfolio?
- Does market sentiment seem excessively bullish or bearish?
- Am I placing the right weight on this event, versus historical data?
- Am I considering the possible opportunities as well as the risks?
Focus on your long-term goals
There is always uncertainty on the horizon. This may lead to news which surprises, both on the upside and the downside. Such events can lead to investor and market overreaction in the short term. Emotions play a surprisingly significant role in investing. Successful investing requires investors to have an appreciation for, and control over, their feelings.