Volatile markets and behavioral biases

February 1, 2008

After years of low and declining volatility, investors have had some adjustments to make in the last six months or so. Volatile markets, especially falling ones, can play tricks on the mind. None of us are immune to the various behavioral biases that have spawned the now popular field of behavioral finance. Being aware of those biases should help, however, and I recently decided to review the literature to be better protected from my own rationality. As a guide, I used Behavioral Finance and Wealth Management by Michael M. Pompian, which I would recommend as an introduction to the field.

Out of the 20 biases Pompian discusses, I have singled out 8 which I consider most relevant at this time. In order to keep my blog posts within reasonable length, I will divide these into two sections. The biases are separated into emotional biases and cognitive biases. This post will deal with emotional biases and the next one with cognitive biases. I am not making any specific recommendations, but merely reminding you to be aware of these common pitfalls. Read the rest of this entry »

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Deleveraging and volatility – The Icelandic example

August 21, 2007

It is doubtful that any level of sophistication in the use of financial instruments will ever create a new paradigm of permanently lower volatility. Complicated derivatives and securitizations are useful in creating new ways of pricing and transferring risk, however they do nothing to change basic human emotions such as greed and fear, nor do they change people’s appetites for risk.

After a prolonged period of low volatility, investors start to feel comfortable taking on greater risk, often with borrowed money. No matter what the latest risk control methods are, it is inevitable that an increase in risk-seeking behavior and use of leverage will eventually lead to a spike in volatility, as has been witnessed in the markets in recent weeks. Read the rest of this entry »