Market volatility and investor behaviour

The impact of novel coronavirus (COVID-19), like some previous pandemics, has led to stock marketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or traded.+ read full definition volatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition. It can be a stressful time. Take care of your health and follow the advice of public health authorities.

Volatility is the rate at which the price of a security increases or decreases for a given set of returns. A stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition price that fluctuates frequently by significant amounts is very volatile. As a result of COVID-19, the capital marketsCapital markets Where people buy and sell investments.+ read full definition in Canada have become very volatile.

Stock prices primarily reflect investor beliefs about the value of a company. Changes in investor beliefs can cause the value of a company to change due to the market forces of supply and demand. Prices decrease when more people want to sell a stock than buy it.

Traditional economic theories cannot fully explain the movement of the stock market. Behavioural economics has revealed that stock prices can change due to biased or emotional decision making. Investors tend to make more decisions based on biased or emotional decision-making during times of increased volatility, such as the COVID-19 pandemic. Three key biases that become more common during market turbulence are affect, herd behaviour, and loss aversion.

Affect

Affect is a decision-making shortcut in which good or bad feelings influence decision making. These are emotional, rather than logical, responses to information. Affect typically changes how individuals perceive the benefits and risks of decisions. In general, if information relating to the decision makes us happy, we tend to perceive the benefits of the decision as higher. We see decisions as riskier if the information relating to the decision causes negative emotions.

Due to Affect, emotions play an important role in investor decision making. This is especially relevant during times of market turbulence. One of the most significant emotions during these times is fear. During a sudden drop in markets, fear is triggered in many investors. This fear may cause some investors to overestimate the risk that they will lose all their money. This is irrational if they have a well-diversified portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition. The irrational fear of losing everything may cause them to panic and needlessly sell assets for a loss.

Herd Behaviour

Herd behaviour occurs when individuals do what others are doing rather than making decisions based on their own knowledge and information. Herd behaviour can lead to entire groups making irrational decisions. This commonly occurs to investors during market bubbles and crashes. During a bubble, irrational optimism drives the prices of assets well above their fundamental value. Collective pessimism often plays a significant role during market crashes.

New information, such as a global pandemic, can cause a rational decrease in stock prices.  The new information will cause some investors to become pessimistic of the value of certain stocks and they will sell. Herd behaviour may take over at this point as investors begin to sell merely because others are selling. This collective pessimism can lead to a crash that causes the prices of stocks to drop below their fundamental value.

Loss Aversion

Individuals do not feel gains and losses equally. We psychologically experience losses twice as strongly as gains. Put simply, losing $100 hurts more than gaining $100 feels good. Loss aversion becomes very problematic during market turbulence. Even if the value of your portfolio is the same before and after the period of turbulence, it will feel as though you are worse off.

One way that loss aversion affects our decision making is that it makes us try to avoid risk. The pain experienced from losses during market volatility can lead to investors becoming risk averse. This is problematic since all investing involves risk. Risk averse investors may overestimate the risks associated with their portfolio and decide to change their investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition strategy to a more conservative approach that is not aligned with their long-termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition investment goals.

Affect, herd behaviour, and loss aversion are some of the behavioural insights that become more prevalent during times of market volatility. Learn more about how the COVID-19 pandemic is affecting your investments and some tactics to ride out the turmoil.

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