Can professional golf help explain what is now happening with the stock market? I think that it can, because it offers a clue about an important source of this month’s market volatility: human psychology.
The best golfers make par on most holes. They also have plenty of chances to make a welcome birdie (one under par) or to avoid a dreaded bogey (one over par). To do either, they have to sink a putt.
A stroke is a stroke, so you might think that whether a pro makes a putt can’t possibly depend on whether the result would be making a birdie or avoiding a bogey. But you’d be wrong.
A study of over 1.6 million putts shows that professional golfers are significantly more likely to succeed in sinking a par putt than a birdie putt of equal distance and difficulty. Remarkable but true: If the average top golfer putted as well for birdie as he puts for par, he would make an additional $1.2 million a year.
Why do golfers do so much better when they are putting for par? The best explanation, coming from behavioral science, is that most people are “loss averse,” meaning that they dislike losses a lot more than they like equivalent gains.
A loss from the status quo is very painful, and so people will do a lot to avoid it. A gain is good, but it isn’t nearly as good as a loss is bad. Like the rest of us, professional golfers are affected by what John Maynard Keynes called “animal spirits”: the feelings of the primitive creatures who lie within us. Hating the prospect of losses, golfers focus intensely on avoiding those bogeys, and often succeed.
Which brings us to the stock market. Of course it’s true that the recent volatility, and the sharp declines, have a lot to do with real-world events, including slower growth in China and rapidly falling oil prices. But the fundamentals remain pretty solid, and the ultimate effects of such factors are at least partly a product of psychology.
Investors know that stocks go up and down, but losses loom much larger than gains, and when the market gets especially volatile it’s tempting to sell. Even if your portfolio ends up the same on March 15 as it was on February 15, the interim losses tempt many people to get out. And if it’s a terrible month, a lot of people will want to avoid more bogeys – and scale back their holdings.
A closely related phenomenon is called “probability neglect.” When an outcome stirs strong emotions, people tend to neglect the likelihood that it will occur. If the prospect of a bad result gets the heart racing – a plane crash, a terrible disease, a loss of 30 percent of your portfolio — most people will take strong steps to avoid it. They will pay too little attention to a comforting thought, which is that worst-case scenarios usually don’t come to fruition.
Loss aversion and probability neglect operate at the individual level, but much of our behavior is a product of social interactions, which multiply their effects. Even when the fundamentals are strong, making significant market declines unlikely, investors are affected by the actions of other investors. Like a bank run, a decline in stock prices creates its own momentum. In the most extreme cases, what happens, and what we are now witnessing, is an “informational cascade,” in which investors attend to the signals given by the behavior of other investors, even if their own information suggests that the other investors are wrong.
Informational cascades help fuel sell-offs. If many investors are perceived to be selling, there is a snowball effect, as the “should sell” signal gets louder, not because people have reliable information that selling really makes sense but simply because of the behavior of others.
The good news is that in ordinary circumstances, investor cascades are halted. The smart money is aware of everything I have said here, and if the fundamentals really are strong, savvy investors start buying. They aren’t loss averse, they don’t neglect probability, and they spot opportunities when they see them. If there are enough of them, they can stop and eventually reverse dramatic movements driven by animal spirits.
History tells us that in the long-run, equity markets will do just fine. In the short-run, however, the prospect of bogeys can create a lot of havoc, especially if a lot of people decide that they want to get out of the game.
— Check out Why Clients Don’t Take Your Advice on ThinkAdvisor.