The Asymmetry of Emotion and the Uptick Rule

Would you rather make $100 dollar, or lose $100 dollar?

Think carefully about this question…

Now let me ask another question.

Would you rather have the hope and joy of possibly making $100, or the fear and regret of possibly losing $100?

The difference between the two questions is crucial to our understanding of the asymmetry of emotion. I use the word “asymmetry” because of the difference in behavior when one feels hope for the future, versus when one feels the fear of what’s to come. Hope tends to be much longer lasting than fear. In the context of the stock market, hope pushes markets higher, while fear drives them distinctly lower.

But the asymmetry of the reaction to hope and fear also makes markets asymmetric in the way advances and declines happen. What I mean by this is that markets tend to go up (hope) over long periods, whereas declines (“corrections” characterized by fear) tend to occur swiftly, and can conceivably remove months of positive returns in just a few weeks.

So, a fundamental question to me is whether or not this asymmetry results in short to intermediate term market inefficiencies. After all, people tend to “underreact” to hope (leading to markets moving higher over long periods), and overreact to fear (leading to sharp and potentially brutal losses in much shorter periods, barring a recession of course!).

Overreaction is an inherent form of inefficiency – it completely counters the idea that investors exhibit utility traits, i.e. don’t feel any difference between gaining a dollar versus losing a dollar. In reality, people would rather not lose a dollar than make one (“loss aversion”), making their reactions to loss have greater magnitude.

What does the Uptick Rule have to do with any of this? For a moment, let’s go with the not so far-fetched assumption that the emotion of fear is fundamentally not only destabilizing to the market, but also causes overreactions and subsequent pricing inefficiencies. If that assumption is true, then doesn’t the Uptick Rule actually make markets more efficient by putting a barrier on the overreactions caused by fear?

The Uptick Rule was removed in early July of 2007, allowing traders and investors the ability to short stocks on a declining price tick. Does its removal make fear happen more frequently by allowing traders and investors to bet on a declining market freely, and does that snowball into even lower prices, more fear, more shorting, more market inefficiencies, more overreactions etc., etc.?

Markets do seem to be a lot more volatile these days…

Comments

[Go West]

Good thinking, but your conclusions are incorrect. Markets are efficient when all information regarding a security(s) is known and reflected in the price. Anything that impedes information being immediately reflected in the price reduces efficiency. The uptick rule was an impediment.

[EL-GRECO]

The press have been conspicuously silent about this rather important point. Who benefits from higher volatility? Surely it's the big brokers, hedge funds and the market makers. Stability in markets is great for buy and hold retail investors, but perhaps it also makes retail investors look too good against the performance of hedge funds. Stability in markets its boring for the media, which likes to portray the market as one big casino. Perhaps all of these reasons are why no one talks about the removal of the uptick rule.