What is behavioural finance and how does it help explain recent market volatility?

by Jonathan Adams
behavioural finance

Stock market volatility has reached unprecedented levels over the year since the coronavirus crisis sparked a sell-off that started from late February 2020. Major economic crises are typically accompanied by stock market volatility, but this time feels different.

Recent stock market zig-zags are being driven less by nervous institutional investors trying to navigate their way through choppy waters and more by retail investors. Lockdown conditions over much of the pandemic and a raft of new cheap, easy-to-use, trading and investing apps have attracted millions of small retail investors – many of them young Millennials and even Gen Z-ers.

Together, these massed ranks of retail investors are changing historical market patterns. All the evidence suggests they are far more driven by behavioural finance than large institutional investors who typically take longer-term, more fundamentals and data-based decisions.

In this article, we’ll take a closer look at the rising influence of retail investors on financial markets dynamics, what behavioural finance means, how and why it is driving volatility and what it means for long-term investors focused on more traditional data-based valuation metrics.

Covid-19 pandemic-induced market volatility

Volatility levels across wider markets have been high over the past year, as can be seen from the VIX gauge, which tracks positions on S&P 500 futures.


The tech-heavy Nasdaq 100 index has been even more volatile. As of Friday March 12, the index had moved at least 1% on eight of March’s 10 trading days. On Monday it fell by 1.9% before gaining 4% Tuesday. The index then took a different direction in each of the next three sessions before finishing the week down 0.9%.


Source: Bloomberg

Tech stocks are being heavily influenced by bond yields. When 10-year yields rose last week, tech stocks fell. When yields retreated, tech stocks soared. A number of analysts have warned they fear the 10-year benchmark yield hitting 2% could spark a Nasdaq 100 correction of up to 20%.

Retail-traders not institutional investors driving volatility

Historically, market volatility is driven by large institutional investors moving hundreds of millions of dollars around as their sentiment shifts from risk-on to risk-off and back again. But the huge influx of small retail traders into markets over especially the past year means, as a group, they now have enough clout to move markets themselves.

The analyst Larry Tabb told the FT that retail trading has accounted for as much activity as mutual funds and hedge funds combined in the last year. The result has been a big increase in “noise trading” – money piling in and out of stocks and other financial instruments currently generating significant media coverage and discussion in retail investor forums like the subreddit #WallStreetBets.

That’s led to extremely high levels of volatility for individual stocks. Electric car maker Tesla is down 21% from its high in late January, despite a 16% rebound this week. Apple has seen its share price drop over 4 of the last 5 weeks, and streaming giant Netflix fell in three out of the last four weeks.

That’s pushed a measure of 10-day realized volatility in the Nasdaq 100 toward 40, close to price swings in the Russell Microcap Index, where half the constituents had no earnings in the past year.

But despite the relatively extreme levels of volatility in these big tech stocks, others have seen even greater volatility. Especially a handful of small-caps that have been particularly popular targets for the #WallStreetBets crowd who have taken it upon themselves to trade against hedge funds with short positions.

The primary goal of these retail traders is not even to make money. That is a welcome side-effect but their first priority has simply been to attack hedge funds seen as financial markets predators. If hedge funds are know to have extensive short positions in a stock, thousands-strong groups of retail traders have been taking long positions to drive up valuations and ‘squeeze’ the shorters.

At a certain point, traders with short positions are forced to close them and lock in losses if they don’t have the capital reserves, or risk appetite, to wait out the retail investor crowd specifically targeting them. These cat-and-mouse stand-offs have led to the kind of volatility that can be seen below for GameStop – the previously unremarkable, and struggling, video games retailer that has become an icon of the recent rise of the retail trader’s influence on stock markets.

gamestop crop

Between the 21st and 27th of January GameStop’s share price rose by over 700%. It then dropped by over 40% in a single day between January the 27th and 28th, before gaining almost 70% the next day. Over the following week the company’s valuation slumped by around 85% and more recently, between February 23rd and March 12th, gains of 488% have been recorded.

That kind of volatility for a single stock over a 3-month period is unprecedented. GameStop’s valuation swings also have absolutely nothing to do with the company’s financial performance. They are being driven purely by massed ranks of retail investors following the crowd.

What is behavioural finance?

Behavioural finance is defined as:

“… psychological, cognitive, emotional, cultural and social factors on the decisions of individuals and institutions and how those decisions vary from those implied by classical economic theory”.

Another way of putting it is that behavioural finance is investment decisions made on intuition, emotion or herd mentality instead of traditional valuation metrics like real world supply and demand, current and predicted future financial performance.

Why are retail investors currently more influenced by behavioural finance than ever before?

As a group, retail investors have historically been more prone to investment decisions influenced by behavioural finance. But that tendency has been magnified recently. Many market observers put the trend down to the design of the new generation of trading apps like Robinhood.

Trading apps aimed at especially younger retail investors are designed in a way that simplifies and encourages quick investment decisions. A study published in February explains:

“The simplification of information on the Robinhood app is likely to provide cognitive ease to investors, leading them to rely more . . . on system 1 thinking and less on system 2. Robinhood only provides five charting indicators [for evaluation], while [online trading platform] TD Ameritrade provides 489.”

The ‘system 1’ and ‘system 2’ referred to are the ‘fast’ and ‘slow’ ways of thinking explored by the psychologist Daniel Kahneman in his popular book Thinking Fast and Slow. The book examines two kinds of human thought. The first, fast thinking, is based on intuition and ‘gut’ feelings.

The fast mode of thought is necessary to dealing with many of the everyday decisions we make. It’s not practical to deeply analyse everything if we want to get things done. Fast thinking allows us to take decisions quickly based on previous experience and the intuition it informs. But it also means psychological biases often find their way into decisions taken as a result of ‘fast’ thinking.

Slow thinking is considered analysis of visible and less visible data points and a conscious effort to remove emotion from the decision-making process. While fast thinking decisions have always influenced financial market volatility, long term trends are more associated with slow thinking. It’s the basis on which investors have faith ‘undervalued’ or ‘overvalued’ stocks will eventually return to a valuation in line with their fundamental financial performance.

Right now, fast thinking behavioural finance is having much more influence on financial markets than historically.

How should investors adapt to the new emotionally-charged volatility of financial markets?

Some observers expect the retail investment craze to fade away post-pandemic. Others are confident at least a significant number of the younger investors who have taken a new interest in trading and investing will continue to do so.

If markets continue to be more influenced by behavioural finance, will that impact long-term outlooks for more traditional investors? It’s hard to say. Increased levels of volatility may become the norm if retail investors retain more influence in financial markets. But companies and other financial instruments would still be expected to return to somewhere akin to valuations based on actual financial performance eventually.

That should mean things don’t change dramatically for long-term investors. If they can ignore short-term volatility and resist the temptation to take decisions influenced by it.

Others will see an opportunity to profit from behavioural finance-driven volatility. For those willing to take that risk, an opportunity may be approaching. A recent survey by Deutsche Bank suggests that half of U.S. investors aged 25-34 with a brokerage account will put half of whatever they receive from Joe Biden’s upcoming $1.9tn stimulus package in the stock market. Deutsche thinks this could generate $170bn of new inflows.

Combined with markets sighing in relief at lockdowns ending, that inflow of capital from retail investors could well lead to another stock market surge this spring. That could be an opportunity for investors to achieve quick, significant returns.

The question is, what happens once that potential new stimulus-driven bull market runs out of steam? And are you confident you can time your entry and exit right?

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