3 Behavioral Biases To Watch Out For When Volatility Is Back

by: Nelli Oster

3 Behavioral Biases to Watch Out for When Volatility is

Rate sensitive assets experienced a marked pickup in volatility earlier this summer as investors digested the possible impact of the Federal Reserve (the Fed) tapering its asset purchases.

And while volatility is now back to spring lows, it's likely to pick up again coming into September, when the Fed's tapering announcement is currently expected, and Germany holds federal elections.

Unfortunately, when markets are volatile, it can be harder to invest rationally. The more volatile and noisy returns data are, the more difficult it is to evaluate whether past investment decisions and strategies worked. Such uncertainty and ambiguity tends to aggravate investing-related psychological judgment errors like those Russ Koesterich and I highlighted in our recent paper Breaking Bad Behaviors.

The good news is that if investors are aware of the bad behaviors that they may be most prone to during periods of higher market volatility, they can perhaps better avoid them. So, here are three behavioral biases investors should specifically watch out for during more volatile times, as well as some tips for how investors can potentially overcome them.

1) Beware of the herd

In other words, investors should try to avoid blindly following others when it comes to making investment decisions.

Social psychologists have shown that to minimize conflict in a group setting, people often rely on the group's opinion, rather than their own, in making decisions. For example, an investment club's opinion may trump that of an individual's, with a potentially detrimental impact on performance. A study of a large discount brokerage between 1991 and 1997 estimated that in a sample of 166 investment clubs, on average the clubs underperformed the market by almost 4 percentage points a year, and underperformed individual investors by around 2 percentage points a year.

Herding also extends to professional market participants. Sell-side security analysts often cluster their earnings forecasts in a small range, especially when they have little forecasting experience or when uncertainty is high, as measured by the ease of earnings predictability, or the difficulty of the forecasting task.

Experimental evidence shows that higher uncertainty may also lead to more herding in investment choice. When uncertainty is high, investors are likely to feel less confident about their own information and mimic the positionings of other market participants, who they feel may have better quality information.

While going with the herd may seem like an appealing proposition and could even produce good returns for a while, groupthink can ultimately lead to falling victim to financial bubbles and crashes. Because market timing is extremely tough, individual investors with limited resources for investment analysis who merely follow the herd risk getting into the markets too late, buying when bull markets have already run their course and selling at the bottom.

One way investors can potentially avoid this bias is by employing contrarian strategies, such as value investing, that have historically tended to produce more consistent returns over the long term. Those still wishing to invest with market sentiment need two building blocks in their analysis. First, they need a market sentiment gauge, e.g. the VIX, or a composite measure such as my team's in-house risk appetite index, which consists of past equity market returns, credit spreads and growth expectations to come up with a monthly measurement for market sentiment.

Secondly, investors need to determine the sensitivities of various assets' returns to shifts in their chosen sentiment measure. For example, when sentiment turns bullish, more volatile, higher risk emerging markets stocks have historically tended to outperform safer US stocks. The challenge here is that the sensitivities need to be forward-looking in nature. For instance, with the Fed gradually turning less accommodative and rates ultimately backing up, some traditionally more defensive sectors, such as US utilities, are likely to continue to face pressure, even during risk-off periods, thanks to their high-dividend bond proxy status.

2) Don't let excessive trading erode your profits

A study of the customers of a large discount brokerage demonstrated that individual investors often trade excessively, with those trading the most earning an average annual net portfolio return of 11.4% between 1991 and 1996, versus the market return of 17.9%. Men trade on average almost 50% more than women, underperforming women by 0.94 percentage points a year. This is consistent with the psychology literature finding that men tend to be more overconfident in their own skills than women, and therefore react too much to unreliable market information.

Overconfidence can also develop over time, when a trader over-attributes positive performance to his own skill. This type of overconfidence generally disappears slowly over time as the trader learns about his true ability by observing the outcomes of his previous trading decisions.

However, this learning process can be slower if market feedback is ambiguous, as likely occurs when volatility picks up. Generally speaking, the higher the uncertainty and volatility in the markets, the harder it is to infer whether one's own past investment decisions were correct, and the more time it takes for any overconfidence effect to diminish. This, in turn, means that during volatile periods, people may continue to trade excessively for longer, potentially hurting their portfolio performance net of fees.

To mitigate the tendency towards excessive trading, investors should keep in mind the overall horizon over which they expect their financial goals to be achieved, and consider rebalancing their portfolios at set intervals such as, for example, quarterly.

3) Don't let fears and potential regret paralyze you

Ironically, when uncertainty in the markets increases, investors may also engage in the exact opposite of excessive trading. Individuals, especially those with little investment experience and little confidence in their own investing abilities, may get paralyzed into the status quo, feeling not quite sure what to do. Fear of potential losses, and of the psychological pain from regret over any poor investment decisions made along the way, may induce inertia. For instance, a study of two different brokerage firms showed that consistent with the notion that regret may drive investment decisions, individual investors are reluctant to repurchase stocks that they have previously sold for a loss, as well as stocks that have done well since they previously sold them.

There are two important mechanisms underlying this status quo bias: loss aversion and the endowment effect. Loss aversion refers to individuals' tendency to focus on gains and losses around a reference point, often the status quo or the price at which a security was purchased, and to experience pain from losses more strongly than pleasure from gains. People subject to the endowment effect value what they own more than identical products that they don't own and as a result, prefer to retain their possessions, as forgoing them feels like a loss. Individuals' negative reaction to uncertainty and losses can bias them towards the status quo and create the endowment effect.9 Put together, the higher the degree of uncertainty, as captured in the market context by the volatility of returns, the larger potential losses may loom, the stronger the feelings of regret may be, and the less an investor may wish to act at all.

Yet, when the world changes, portfolios need to be rebalanced to reflect the new investing environment. Again, investors may want to stick with moderation, rebalancing their portfolios at set intervals and focusing their analysis on future expected returns rather than letting past gains or losses, or emotions such as fear and regret, drive investment choices. Avoiding excess attention to security specific risks that can be diversified away in a portfolio and focusing on investment goals over the longer horizon, which tends to smooth out short-term fluctuations, may help mitigate loss aversion and the status quo bias. Those interested can read more about this in the "Taking the Plunge" section of my recent Breaking Bad Behaviors paper.

In short, uncertainty and market volatility may aggravate investors' behavioral biases. As I write above, to avoid succumbing to the mercy of emotions, such as fear and regret, in investment choice, investors should consider a focus on longer-term investment goals together with a systematic investment approach, portfolio diversification and regular rebalancing.

Let's continue the conversation in the comments section below. What less-than-rational investment behaviors have you personally observed in more volatile markets, and can you think of any additional ways of potentially tackling them?

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.