What comes first—Volatile markets or irrational investors?
Does market volatility make investors behave irrationally? Or do irrational investors cause the market to be volatile?
It may seem like a chicken-or-egg debate but it is a useful discussion to have, especially as investors struggle to stick to their investment plans and find themselves off-course from their investment goals.
Let’s look at recent activity in the stock market to uncover some insights that can help you as an investor manage through volatile market periods.
In the fall of 2014, the stock market experienced one of its more turbulent periods in recent years. During this time, the benchmark S&P 500 Index fell 9 percent from its September peak through mid-October.
Such a swift and significant drop in value may seem crazy and irrational, especially for investors in the throes of the market’s decline. But the market’s drop was perfectly rational, as slower overseas growth, rising market valuations and the eventual ending of the Federal Reserve’s accommodative monetary policy affected the equity markets.
What really was irrational was the reaction of investors. Throughout that brief spell of market volatility in 2014, 401(k) investors traded out of their stock positions at a higher than normal rate, according to an analysis by benefit consultants AON Hewitt. There were seven days of moderate or high trading activity during those few weeks that fall. In the previous nine months, there was a total of 12 days of above-normal activity.
This outcome is not uncommon or unexpected. Often, there is not one singular event to point to as a cause for a market decline. Investor panics build on a series of irrational reactions as worry spreads and turns to fear.
Think of how a herd of cattle would react to a snake in their midst. The first cow to come across the snake would back away—a natural and rational reaction to perceived danger. But other cows would feed upon this initial response and turn fearful. This fear compounds within the herd until a full-blown stampede is underway.
In much the same way, investors react irrationally and emotionally to what are rational movements in the markets. It is this herd mentality investors must guard against. That can be difficult for individuals to do on their own, with all of the emotions they must contend with.
Fortunately, individual investors do not have to do it alone. Independent investment advisors like us can help investors be their own best advocate, with objective and logical strategies for managing the irrational reactions to market volatility that are part of human nature.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.