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Posted on May 18, 2020

Emotional Markets and Volatility Explained

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By John Corron, Wealth Advisor –

What a run of market volatility we have experienced since COVID-19 captured the world by storm!

After such a long run of stable and positive market returns following the Great Financial Crisis of 2008 to 2009, the magnitude of day-over-day up and down market moves have been stunning for many.

A popular question that I am asked is, “What is different this time?”

While there are many fluid moving parts to the current market environment, I try to explain it in the simplest terms I can think of: emotion, market structure and illiquidity.

What is “The Market?”

For many of you who watch the news and practitioners alike, Wall Street is often the first definition of “The Market” that comes to mind.

The Wall Street collective is a combination of banks, asset management firms, hedge funds, insurance companies and even large corporations. But in reality, if you are a saver and have money invested – you are a part of the market as well.

There are millions of individuals who save and invest, far more in number than all financial institutions combined. Individuals carry heavy weight in markets when deciding to buy and sell together at the same time.

While mutual fund and asset management companies represent financial interests for a majority of us who save and invest – ultimately their fortunes and activities are directed by the preferences and behavior of the individuals who entrusted their savings to them.

Why do emotions matter?

In environments like the one we are currently in, the extremes of market volatility are magnified when fear grips investors. Fear of the unknown drives panicked selling.

When news headlines get scary, many investors sell as soon as possible and ask questions later putting their comfort in cash. Mutual fund and asset management companies sell assets to raise cash to fund expected redemption requests sent to them by fearful individuals.

If there are few willing buyers of the securities they are trying to sell, sharp price declines can occur – media outlets highlighting these price declines cause more fear, more requests for redemptions, more selling to fund redemptions, etc.

At the end of the day, many financial institutions do not want to be forced to sell. They must often accept low prices for their securities because buyers know they can charge a higher price for providing the seller with an opportunity to exchange assets for cash.

It is a vicious cycle and driven by many individuals’ preference for cash and safe assets even though they are unsure of how the situation truly is.

We’ve seen big up days too. Why is that?

Imagine that you bought a stock on Monday for $100 and its price dropped to $80 on Tuesday. If I came to you on Wednesday and offered to buy it from you at $85, would you sell it to me?

Maybe not at $85, but you might be willing to sell at $88 so you can take less of a loss on a more volatile stock than you bargained for. I was willing to pay up to $88 for your stock that was valued at $100 2 days earlier. Fear of heavier losses causes you to entertain selling at a $12 loss within 3 days.

Maybe this seems irrational, but it’s human nature to avoid pain and uncertainty.

So, what just happened?

You experienced a 20% loss on Tuesday and a 10% gain on Wednesday. Historically, those are very large one-day price changes, but that is what we are experiencing. There are buyers and sellers active in markets every single day – just not enough of them willing to participate on the same days lately.

Why does market structure matter?

Simply put, the structure of the trading market is the community of buyers and sellers willing to transact in securities.

In the aftermath of 2008, heavy regulation went into effect aimed at creating more stability in the global banking system. Large banks ended up reducing participation in risky activities, largely in public securities markets and subprime lending.

Prior to 2008, there were many more buyers and sellers in securities markets and the larger institutions were able to buy and sell more than they are today. The market environment back then led to institutions taking excessive risk, which was a contributor to the crisis.

We’re now seeing the impact of how market structure and regulation has changed since 2008.

Fund and asset management companies are significantly larger than they were in 2008, but they are designed to buy and invest for the long-term – not necessarily make markets in securities when volatility spikes.

The buyers of last resort are not currently equipped to function as they need to in times of stress. Extreme volatility is a consequence.

What is illiquidity?

Liquid securities can typically be sold for a value close to their closing value from the previous trading day – however, they cannot be sold quickly at that price.

In times of stress (when buyers and sellers are not willing to transact with one another), even usually liquid securities can trade like illiquid securities, which leads to larger-than-normal price swings.

The smaller number of willing buyers and sellers contribute to this dynamic – this smaller community dealing with an environment of fear and panicked selling magnify illiquidity.

What’s the Point?

The combination of emotion, market structure and illiquidity is a less disruptive cocktail in times of certainty and calm. Uncertain periods where fear is front-and-center, however, bring out the negative potency of the trio’s impact on market stability and investment returns.

This blog post is not meant to indicate that the fear being felt by investors and the general population is irrational. It is meant to describe how intertwined investors and institutions are, big and small, and how our behavior is magnified by the current structure of markets.

We all play a part in how markets ebb and flow.

I have tried here to explain why and how markets can overshoot in volatile periods. These volatile times present opportunities for investors who have a plan in place to take advantage of uncertainty in markets.

Understanding why markets react the way they do is an important part of planning.

Hopefully you are a little more comfortable in understanding how our interconnectedness and actions impact everyone’s wealth. It is often the case that greater returns are experienced by those who follow their plan and stay the course rather than react to the impulse of fear when times get tough.

I wish you well in navigating these uncertain times.

If you could use some help or guidance we’re always happy to connect.

 

The opinions are those of the writer, and not the recommendations or responsibility of CWM LLC or its representatives.