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The psychology of market volatility

WHAT IS MARKET VOLATILITY?


Market volatility describes the magnitude and frequency of the degree of variation or fluctuation in the price of a financial instrument or asset in the stock market within a certain period.

It is a measure of the degree of uncertainty or risk in the market and reflects the speed and magnitude of price changes. Therefore, oftentimes it is used by investors to help predict future price movements.




HOW DOES IT WORK?


Measuring market volatility is often done by using statistical measures such as standard deviation, beta, and the volatility index (VIX). These metrics allow investors to assess and manage risk effectively by gaining insights into the past and expected future fluctuations in asset prices.

Understanding the relationship between volatility and perceived investment risk is fundamental in financial markets.

Higher volatility typically signifies greater uncertainty and fluctuation in asset prices, leading to the perception of increased risk among investors. Due to the potential for larger price changes, these kinds of investments are often viewed as riskier and have the potential of bigger losses.

In contrast, lower volatility suggests a more stable and predictable investment environment, reducing the perceived risk and offering investors a sense of security with less potential for losses. Understanding this relationship allows investors to assess the level of risk associated with different investment opportunities and tailor their portfolios accordingly to achieve their financial objectives.

The relationship between volatility and the perceived investment risk can be summarized as the following:

Higher Volatility → Higher risks due to more frequent fluctuations and a greater potential for losses

Lower Volatility → Reduced risks with a more stable environment and less potential for losses






WHAT CAUSES MARKET VOLATILITY?


Market volatility is a natural and inherent characteristic of financial markets, influenced by a complex interplay of economic, geopolitical, psychological, and technological factors, that influence investor behavior and market dynamics.

Several factors contribute to market volatility, including:

·        Economic Indicators: Economic data releases, such as GDP growth, inflation rates, employment figures, and consumer confidence reports.

·        Geopolitical Events: Can create uncertainty in financial markets, resulting in heightened volatility as investors adjust their positions in response to changing risk perceptions.

·        Market Sentiment and Investor Psychology: Buying activity can be stimulated by positive emotion, while selling pressure can result from negative sentiment, making price fluctuations more pronounced, especially in times of panic or market uncertainty.

·        Interest Rates: Particularly in bond markets and interest rate-sensitive sectors such as real estate and utilities.

·        Market Liquidity: The likelihood with which transactions may be carried out can be influenced by the number of buyers and sellers in the market as well as the size of the order book. 

·        Technological Factors: The velocity and frequency of trading activities in financial markets have increased due to technological developments, algorithmic trading, and high-frequency trading, which triggered market volatility.

·        Earnings Reports: Positive or negative surprises in earnings results can lead to sharp price movements and increased volatility as investors reassess company prospects and future earnings potential.

·        Monetary Policy Decisions: The activities of central banks have the power to shape investor behavior and market expectations. and equity markets as investors adjust their positions in response to changes in interest rates and inflation expectations.

·        Global Economic Events: Trade agreements, fiscal policies, and trends in economic growth in the world's major economies can all influence the world's financial markets and raise volatility.

·        Seasonality and cyclicality: Depending on the stage of the economic cycle, some businesses are more sensitive to changes in prices. Although regular seasonal shifts are generally more predictable, share values can still move significantly around important dates.




HOW CAN WE TRACK IT?


Market volatility is measured by finding the standard deviation of price changes over a period of time. Standard deviations show how much a value may change, while providing a framework for the odds it will happen. In practice, the higher the standard deviation, the more that portfolio is going to move around, up or down from the average.


VIX

One of the most widely used measures of market volatility is the CBOE Volatility Index, known as the VIX. The VIX is often referred to as the “fear index” and it estimates the S&P 500’s implied volatility by looking at the prices of options on the underlying equities tracked within a 30-day time frame, which is then annualized to determine a formal prediction.

Tracking the VIX allows investors to gauge market sentiment and assess the level of uncertainty in the market. Generally, the higher the VIX, the more expensive the options. If the VIX is high, the stock prices in the market fall, and investors allocate more of their capital to fixed-income securities like treasury bonds, corporate bonds and “safe havens” like gold.

Some other ways to track market volatility include:

  • Volatility ETFs and ETNs

  • Historical and Implied Volatility

  • Volatility Bands and Technical Indicators

  • Market News and Events

  • Option Skew and Volatility Smile/Smirk




THE PSYCHOLOGY OF MARKET VOLATILITY


Psychology plays a fundamental role in financial markets. Although we often tend to think that finance is guided only by rationality given by probabilities, statistics, and analysis of the markets, which should lead to purely logical choices, it is not so. All human beings are in fact subject to emotions, and so, even investors, cannot neglect them and even avoid that sometimes these emotions can take over the investment choices, by encouraging them to make hasty decisions and to make errors of evaluation, which can often result in losses.

For these reasons, the concept of "behavioural finance" is born, with which we mean the study of investor behaviour in situations of uncertainty, through the study of psychology.

Even today, one of the most studied economic theories is the Efficient Market Hypothesis (EMH) by Markowitz according to which, in efficient markets, the price reflects all available information, thus if investors always act rationally. However, efficient market theory has limitations as it does not explain market anomalies such as speculative bubbles and periods of high volatility.

A first turnaround occurred in 1979 with the publication of the article "Decision Making Under Risk" by Kahneman and Tversky, through which the two psychologists explained, using techniques of cognitive psychology, a series of documented anomalies in rational economic decision-making. The article was so successful that Kahneman and Tversky won the Nobel Prize in Economics in 2002. Finally, the concept of behavioural finance is officially recognized following the crisis of 2008.

 



THE INVESTOR PSYCHOLOGY IN MARKET VOLATILITY


Emotions and uncertainty often lead investors to make irrational choices that can negatively affect the stability of financial markets. Therefore, it is important that the investor knows and knows how to manage emotions and the so-called "cognitive biases" to make investment decisions in a more responsible and rational way.

 

There are two emotions that we often talk about in the financial field that play a key role as a driver of market volatility and that is essential to know and deepen: fear and greed.

Fear is the natural response to uncertainty and risk, so in times of high volatility it tends to intensify. When fear takes over, it can lead, for example in periods of recession, to sell the investments before it should because of the fear of achieving greater losses. The onset of this panic leads investors to achieve losses that could have been avoided by waiting the rise of the market that tends to occur after a period of recession.

On the other side, there is greed that leads the investor to want even greater profits and therefore to maintain more than necessary their positions, or it could induce the investor to immediately want to make profits by making speculative purchases.

 

A further trap into which investors can fall are cognitive biases, distortions of the thought process resulting from erroneous perceptions from which incorrect beliefs, prejudices and ideologies arise.

There are several cognitive biases that it is important to identify and have in mind not to fall into hasty decisions.

A first cognitive bias we can define is confirmation bias, which means believe what we want to believe. This prejudice occurs when individuals look for and consider only news that confirms what they already believe, ignoring information that contradicts their belief. This behaviour can lead investors to make bad decisions based on incomplete and distorted information.

Secondly, there is the anchoring bias, which manifests itself when people rely too much to the initial information they receive, basing all subsequent information on it. In the financial field, for example, it can happen that an investor anchors to the past performance of a stock and therefore decides to keep the stock too long, waiting for it to reach that level again even if the market prospects have changed.

There is also the so-called Dunning-Kruger effect, namely the tendency of investors, and people in general, to overestimate their skills and knowledge, leading them to believe that they are better than they are at evaluating and forecasting market movements. All this leads the investor to make hasty decisions and take larger positions than they really know how to handle.

Finally, among cognitive biases it is possible to include the herd effect, that is the tendency to follow the judgement of the majority. This prejudice is precisely what leads to speculative bubbles, initially the enthusiasm and frenzy leads the crowd to buy stocks, thus raising prices; until the bubble bursts triggering the opposite process: all investors want to sell their stocks but without finding the demand, thus bringing prices to collapse.

 

However, there are ways investors can better manage their emotions and cognitive biases:

1.      Develop a solid trading plan: first, it is important to have a well-defined trading plan in which clear objectives, risk management strategies as well as instructions on how to behave to manage market volatility and unexpected market movements are set.

2.      Diversify your portfolio: A diversified portfolio in terms of geography, industry or asset class mitigates risk by reducing the effect of market volatility on your portfolio.

3.      Adopt a long-term time horizon: maintain a position for longer can in fact allow the investor to suffer less than the market volatility and avoid taking too hasty decisions.

4.      Be informed properly: it is important to stay up to date, but it is equally important to know how to distinguish correct information from fake news and know how to choose the right sources. Also, one should not forget to analyse evidence contrary to one’s beliefs, in order not to give in to confirmation prejudice.

5.      Investing little by little: investing smaller amounts but more often can be better than investing in a single solution because it allows you to follow market movements from time to time reducing the risk of high losses in times of high volatility.

 

In conclusion, we can say that emotions such as greed and fear, as well as cognitive biases can lead investors to make wrong and completely irrational decisions. It is therefore important to know how to recognize and manage these factors to be able to better master situations of high market volatility without panic or frenzy.

 

 

 

VOLATILITY IS RATIONALLY USELESS


For most investors, their primary concern is avoiding loss, or reducing their probability of losing capital. Modern Portfolio Theory uses volatility as a measure of risk because it’s relatively easy to calculate and gives a definite number. Many investment funds are judged based on their volatility, either directly or indirectly, through metrics, such as VaR or Sharpe Ratio. The measure has therefore been adopted by finance and investment professionals across the world, who find comfort in its objectivity and simplicity. Volatility does not measure risk; the problem is that many of those who have written and taught about volatility lack an understanding of how to truly measure risk. While we may label it as a measure of past volatility, past fluctuations do not inherently determine the risk associated with an investment. If I purchase a farm at €3,000 per acre, and after one year its value drops to €1,500 per acre, prompting me to buy another farm, conventional metrics like beta might suggest that I am acquiring a risky asset. However, I am purchasing an asset at a 50% discount. The true risk arises from factors such as unfamiliarity with the business or industry in which the investment is situated, not from the performance of the asset in the past; If I hold an amazing company with great future view at a cheap price, why would I care if its price fluctuates all the time? It doesn’t have any effect on the fundamentals of the business.

We shouldn't fixate on minor fluctuations in volatility, such as 1%, 2%, or even 3%; indeed, higher volatility can often be advantageous for savvy investors as it creates market inefficiencies and opportunities to enter sound businesses at favorable prices. Volatility is backward-looking, merely reflecting the risks a stock has faced in the past, whereas investors should be concerned with what the future holds, not what the stock has already experienced. For example, if I invest €100,000 in a company engaged in both oil extraction and fuel production from potatoes (a high-risk venture), and the company decides to divest its oil extraction business, historical volatility will fail to account for this strategic shift.

Moreover, volatility solely focuses on price movements, disregarding underlying value. As value investors, we recognize that stock prices can diverge from a stock's true intrinsic worth. Therefore, mere fluctuations in stock prices do not necessarily indicate a change in the underlying value of the stock.

Risk is dependent on a company's financial health, its valuation, and its ability to generate shareholder wealth. How the market feels about a stock at present has little consequence in the long term.




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