Cortisol the Killjoy
Pfäffikon SZ, Switzerland – In general the movability of the markets, also known as volatility, causes much stress among investors. After all no one likes it when stock prices plummet in no time. Moreover this doesn’t mean that the company in which investments were made has become less valuable – this is a logical error made by many. The VIX-index reflects the volatility and is often used to explain how fearful investors are. However, the VIX-index is nothing more than a model that is correlated with the all-time highs of the S&P 500. Everyone knows that declining markets come into being more rapidly than rising markets do, which would explain how the VIX-index in those cases performs superbly as a panic barometer.
Risk
In our weekly outlook I have also recently elaborated on the fact that a high VIX-index can also be an indication of greed. This character trait of the VIX-index by and large goes underreported. Many investors and journalists translate a high VIX to fear, while in reality the investment’s risk has dropped significantly, which begets greed. After all the price one would pay for the purchase of a given stock is lower, which translates into less exposure and, logically, less risk.
Stress
The question how an investor behaves under stress, is an interesting one. In a recent publication in the Proceedings of the National Academy of Sciences an interesting finding is reported: human beings have no stable preference for risks, but when stress increases, our behavior becomes more risk averse. Cortisol plays a driving role in this process. When this stress hormone is produced it contributes to a widespread risk aversion, which is also described as irrational pessimism.
Instable
A person’s choice in accepting and assessing risks can be labeled as being unstable. When prices are increasing, more risks are taken than during a decline and vice versa. Cortisol responds powerfully to an increase in volatility and a sudden price drop. Oddly enough, during a market decline, investors should in fact be buying undervalued companies, through which the economy stands to benefit in the long run. The psychological shift plays into the hand of instability which is fuel for economists, risk officers but also value investors.
Investors could use this knowledge to their advantage. Next time you see a sharp decline in stock prices and you observe in yourself a heightened level of cortisol, you should ask yourself if this perhaps is the ultimate buying opportunity instead of a time to sell. Tranquility is your savior.
It remains for me to wish you a good weekend.
Jan Dwarshuis is a senior asset manager at Thirteen Asset Management AG, where he is responsible for the Thirteen Diversified Fund. Dwarshuis writes his columns in a personal capacity and is not paid for them. Nor is he paying for his columns to be placed. Professionally, he holds positions in major European, American and Russian stock funds. The information in his columns is not intended as professional investment advice or a recommendation to make certain investments. At the time of writing, he has no position in the other above mentioned shares and has no intention of doing so in the next 72 hours.
