Investors are right to feel jittery. The situation in Ukraine, unusually high inflation in certain parts of the globe, and the lingering impact of the pandemic all pose significant risks to future economic growth. However, the markets ignored such negatives for far too long. It is therefore unsurprising that asset prices have increased in volatility, gyrating between the full spectrum of “buy the dip” optimists to “seek shelter” pessimists.
So,
we’re in an all-too-common situation where investors (and speculators) attempt
to discern the correct price of these risks, creating heightened loss aversion
for as long as the uncertainty exists.
As
is often the case at these inflection points, many will ask: is it different
this time? In today’s case, it is different in the details from what we’ve
experienced till now, but the way investors are responding is more or less the
same as what we’ve seen in other periods of volatility.
First,
let’s start with the unique aspects of the current situation. Primarily,
investors are being asked to weigh downside risks against strong profitability,
low unemployment, and plentiful support from governments and central
banks — with the unwinding of unprecedented stimulus a challenge we’ve
never faced.
Emotional
Responses: Flight, Fright, Freeze
Europe
is closer to war than at any point in decades, which is sure to give people
goosebumps.
Now
let’s turn to what is similar to the past. Periods of sharp price movements
tend to trigger an emotional response from investors as we perceive such
movements as a threat to us. When faced with the perception of such a threat,
we tend to display a "flight, fright, or freeze" response. These
various responses result in particular behaviours in investors, which are
consistent with what we saw in past bouts of uncertainty— including in 2000,
2008, and 2020.
What
exactly do we mean by that? In financial markets asset prices are set by
transactions. Volatility in prices, therefore, indicates that transactions are
occurring across a wide range of prices. This suggests that investors are
unsure about the intrinsic value of an asset given the current confluence of risks.
Those
who display the fight response
are most likely to increase their trading activity during this period,
confidently buying assets that have fallen in the expectation that they will
recover, with little thought to the intrinsic value of those positions.
Those
more vulnerable to the flight response will likely sell their entire portfolio and subsequently tend to remain
under-invested for far too long.
Those
who freeze will do
nothing even when the intrinsic value of their asset is changing.
Each
of these responses places too much emphasis on near-term price movements
leading to potentially devastating consequences for the long-term financial
health of the investor.
The
key to staying a step ahead is to focus on the intrinsic value of the asset, as
over the long-term prices converge with that value. This was something Benjamin
Graham famously called Mr Market, which was notably supported by Warren
Buffett. Sometimes the prevailing price offered by Mr Market (the current price
available) will be above that intrinsic value and sometimes below. Herein lies
opportunity
Watch where your focus is!!
