Market Insights: It’s not as bad as you think
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Market Insights: It’s not as bad as you think

Posted by   Gurdev Aujla on August 15, 2024
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MARKET INSIGHTS: IT'S NOT AS BAD AS YOU THINK

There’s been lots of excitement in the Olympics and also recently in financial markets. So I thought it timely to highlight an interesting paper from Goetzmann, Kim and Shiller (2024) called ‘Emotions and subjective crash beliefs’.

The authors find strong evidence that investors consistently overestimate the probability of a catastrophic stock market crash compared with the historical frequency of such events, and compared with option prices, which are already skewed. They also find that worries rise after unusual exogenous shocks.

For example, investors significantly raise the probability of an earthquake happening after one has happened. Many people will recognise this trait in themselves, with outlook estimates often tainted and adjusted with the benefit of hindsight, reflecting recent events.

Various factors help explain this anxiety. For starters, negative news is more prominent and memorable than positive news. Investors also display loss aversion, so overestimating crash risk is a way to safeguard individuals against potentially irrecoverable personal financial loss.

The authors also note that institutional investors are marginally better calibrated than individuals when estimating crash risk. An example is in geopolitics. It’s difficult to get an edge in geopolitics when tensions are slowly but gradually increasing, so positioning for an escalation or normalisation is difficult as markets normally slightly overestimate the risks but are no better or worse at pricing that risk than we are.

It’s worth noting that most of these tensions pass with little lasting impact on fundamentals. See the chart below for context which shows you’d be much better off staying invested to achieve your outcomes over time. /span>

Source: FE Analytics. MSCI World Index from 3rd January 1972 to 30th June 2024.

Index returns do not reflect management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Please note that this chart is split up into separate bull and bear periods, each of which begins again from zero. So they can be considered as a series of charts run adjacent to each other. A bull/bear market is defined as a 20% rise/drop from its previous peak with a minimum of 6 months duration. Past performance does not predict future returns.

This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security. The views expressed here are subject to change without notice and we can’t accept any liability for any loss arising directly or indirectly from any use of it.

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Gurdev Aujla
Gurdev Aujla

I'm Gurdev Aujla, an Independent Financial Adviser at Coleridge Capital. I specialize in providing a holistic approach to financial planning, focusing on retirement, wealth management, financial protection, estate planning, and setting up wills and trusts. My goal is to help individuals and families secure their financial future with tailored solutions.

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