WEATHERING the storm has lost popularity points with
investors in the latest round of market volatility, prompting some to wonder if
panic and irrationality are the name of the new game.
Investors pulled $31.3bn out of US equity funds in the two
weeks ending August 10, reaching outflow levels not seen since the stock market
collapse of March 2009.
Finding the reason behind that seemingly irrational sell-off
may require more analysis than most economists or stock market watchers can
perform. Perhaps the motivations behind our investing decisions are actually a
question better put to neuroscience.
"Certainly, economic fundamentals play a valuable role
in the value of assets and the prices that things trade for. But when
individuals are making buy-and-sell decisions they can be very influenced on
what is going on in their brains, including emotions," says Lisa Kramer,
associate professor of finance at the Rotman School of Management at the University
of Toronto.
Kramer has done extensive research on how human emotion -
specifically in relation to seasonal depression - influences financial
decisions and financial markets.
"We're prone to weighing recent information more
heavily than more historical information. The fact that we've just been through
a financial crisis in the last couple of years is looming large on our
minds," she says.
"When we see things start to go south again in the
market, we go to that bad place in our minds and I think that can drive us to
act impulsively more so than we would have a few years ago, before we lived
through this kind of volatile period."
This historical hangover, coupled with the understanding of
the body's risk/reward system, has led researchers to hypothesise that an
investor's urge to buy or sell at the wrong time could be a byproduct of our
neural processes overriding reason.
Kramer explains if one were to do a functional MRI analysis
while an investor was in the process of making a financial decision - let's say
whether to buy a stock or a bond - "you'll find that the part of the brain
that's activated when somebody makes the risky choice is called the nucleus
accumbens (NACC) and it's activated when people are experiencing pleasurable
things like food or sex.
"The part of the brain that's activated when people
make the safe choice is called the anterior insula and it's more associated
with pain and fear," she says.
Richard Peterson MD, a former quantitative trader and
managing partner at MarketPsych, agrees, adding investors are still
experiencing anger and mistrust of the financial services industry.
"When people feel disgust, it activates the anterior
insula. That area of the brain is known to prevent risk taking," he says.
"Since the crisis began, no more money has entered the
market. In fact, it has stayed out entirely. People are not reinvesting,
they're feeling disgusted; our data shows that, and it appears to be through
this neural mechanism."
Fear is a self-fulfilling prohecy
Peterson writes in his paper The Neuroscience of Investing:
FMRI of the reward system, that the brain's reward system, connected to one of
the brain's five dopamine pathways, coordinates the search for, pursuit and
evaluation of potential reward.
The activation of this system, when it comes to collective
investing, could have broader implications for financial markets and the
economy.
Activation of the reward system results in particular types
of behaviour and emotion, characterised among investors as greater risk-taking,
increased impulsivity, enhanced positive feelings and greater physical
arousal.
Loss avoidance behaviour and emotions are timid, protective,
fearful, and risk-averse.
When activated among large groups, reward approach behaviour
can impact the economy as a whole, leading to stock market bubbles, increased
consumer purchasing, higher investment risk-taking and an increased use of
credit. Loss avoidance, on the other hand, is seen when people decrease
borrowing, sell off assets, and report decreased financial confidence (and even
fear.)
In terms of behavioural finance and investing, Franklin D
Roosevelt was spot on when he made the now-famous quote "the only thing we
have to fear is fear itself", says Brian Bruce, CEO of Hillcrest Asset
Management and managing director of the Centre for Investment Research.
"The volatility is of our own making. The thing we fear
the most, because we fear it, we create it," he says.
"The frustrating part is you can create this self-fulfilling prophecy. Even if we aren't headed for a recession, if everyone is scared to death - consumers stop spending, businesses stop hiring and stop investing - than you'll create one. If you just act normally, things will be fine."
Advisers are experiencing the byproduct of these emotions,
even for clients in a defensive portfolio position. When it seemed the markets
were on an upswing earlier this year, investors were hungry for gains.
"Over the past six months, I've had to explain to more
clients why they need to stay defensive rather than chasing returns. I can lock
in a return of 8% at some point this year which could turn into a loss of 7% in
two weeks,” says Jeff Link, partner at Guardian Capitol Advisors.
"I have more conversations with clients where I'm
trying to get them to stay the path we've laid out for them, even though it
looks like we may be wrong."
So, what does this type of research mean for the financial
services industry? Understanding an investor's fight or flight mentality is
integral to advisers, writes Gregg S Fisher, a CFA and CFP, in his paper
Behavioural finance from a practitioner's viewpoint.
"For those of us focused on the risk side of the
equation, understanding the behavioural component of the decision-making
process is essential to our understanding of market dynamics - particularly in
periods of financial stress like the past decade, in which we saw two equity
market corrections of approximately 50% each," he writes.
For investors? There are periods of market volatility and
uncertainty that will determine prices, but rational analysis of fundamentals
will eventually prevail. Tune out the market chatter and listen to your
adviser.
"The markets are overly driven by emotion and those
that will profit will understand that they need to take that emotion out of it
and stay calm. Invest on the facts," says Bruce.
Just make sure you and your adviser are on the same page,
Peterson advises. "If you don't resonate with your adviser, you'll jump
off the (investment) plan even if it's solid. If you don't buy into them or
don't trust them, you'll panic when markets are down 23%."