Stock market volatility has picked up recently, as evidenced by last week’s average 2.3 percent intraday swing in the S&P 500. In fact, on Monday of last week the benchmark index was at one point down 3.3 percent, and only a few hours later almost back to flat on the day. As scary as that decline might have seemed at the time, it is still minuscule in comparison to the -20.5 percent drawdown that occurred on October 19th, 1987. That is the largest single-day drop in the market on record, but retail investors frequently overestimate the likelihood of such an event happening again, according to recent research from Yale University’s Robert Shiller and William Goetzmann. Specifically, professor Shiller ever since the ’87 crash has been asking investors what they think the probability is of a similar catastrophic stock market event within the next six months. Over the nearly three-decade sample period, respondents have typically assessed the likelihood of another crash as being around 10-20 percent.
Given that there have been no other “Black Mondays” since 1987, investors are clearly overestimating the probability of another such occurrence. This exaggeration is even worse when an adverse event is being widely reported by the financial media, e.g. surveyed investors would often assign a significantly higher crash likelihood if asked during or soon after a down day in the market. That is just one of the many examples of how investors have a tendency to use easily-recalled information to estimate the probability of an event occurring. Shiller and Goetzmann also found that crash assessments can negatively influence equity flows, i.e. cause a flight from risk assets (stocks), which is bad because it suggests investors are giving excessive weight to short-term fluctuations in the market. That irrationality can cause people to have too low an asset allocation in stocks simply because equities have been under pressure, and too high an allocation after a favorable period for the market, such as when stock valuations are at record levels. Altogether, this study is yet another reason why investors should consult with a professional financial advisor to help make sure that they stay focused on the long-term, refrain from making emotion-based trading decisions, and maintain a portfolio that is appropriate for their unique risk tolerance and nearness to retirement.
Sources: Yale University, SSRN, NBER, ThinkAdvisor
Post author: Charles Couch