How to stay calm in a nervous-cum-volatile market?

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!!