Fanning the Flames
I am a traditionalist when it comes to outdoor cooking: wood and charcoal are the only suitable fuels. I know that gas grills are convenient, but food just tastes better when it’s been exposed to some real fire.
There is an art to barbecue. You need to apply flame to kindling to get the process started, and then manage the heat carefully through venting. If the elements get out of balance, the temperature can spike; getting it back under control is not easy.
I was thinking of this process during last week’s market disruption. Concerns about overvaluation provided the kindling, and worrisome inflation news supplied the spark. But from there, the coals overheated, thanks to a series of forces that were difficult to stop. This essay will focus on the natural accelerants that can exacerbate negative market cycles. This month, we saw them in action for first time in quite a while.
In recent decades, behavioral science has challenged the traditional economic assumption of rational behavior. We now understand that actual conduct is not strictly rational, but it still follows some predictable patterns. Our piece on this kind of “misbehavior” can be found here.
One example is “confirmation bias.” This is the tendency to place more weight on news that substantiates what we already believe, to the exclusion of information that challenges us. When markets are gaining, the rose-colored filter investors use to digest incoming news can lead them to grow more confident that the risk in their portfolio is modest and well managed. When volatility is low, this confidence is heightened.
A second behavioral flaw is known as “rational inattention.” Busy people will have to make tradeoffs in how they allocate their time. Attention is often focused on things which are not going well, limiting examination of more positive trends. Rising markets may not generate sufficient introspection, either among individual investors or those who guide institutional portfolios.
Finally, it is well-established that losses have a disproportionate impact on people relative to gains of the same size. The resulting “loss aversion” is especially powerful when disappointments are large and sudden.
When a market correction occurs, these behavioral factors can lead to a quick shift from an appetite for risk to an aversion to risk. People seize on news that confirms their worst fears, and may take actions to limit their losses in the short term even if they see themselves as long-term investors. With their comfort violated, rationally inattentive investors opt to “just say no” until they have the opportunity to dig more deeply into what’s going on.
All of these elements pushed this month’s correction further than the change in fundamentals might have suggested.