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  • Writer's pictureSteven Schoenberger

Volatility and Behavioral Finance - A Market Update

The third quarter of 2022 felt like a wild ride. We believe that using a principal from behavioral economics and then applying a concept called the Efficient Market Hypothesis (EMH), we may be able to make some sense of the last three months and also provide a view looking ahead.

The behavioral economic concept that we think is apropos for this quarter is called the "Peak-end rule." This idea suggests that past experiences, in this case the last fiscal quarter, are remembered not by an "average feeling," but rather by the most extreme point and the end point of the episode.*

If we use the S&P 500 index as our measuring stick, the full quarter ended down 6.27%. Certainly not great, but much better than Q2 and comparable to several other periods in recent history. If, however, we apply the peak-end rule to look at the same period, we understand why the quarter felt so volatile. We believe the "extreme" point in the quarter was August 16, about halfway through the quarter, where the index had gone up by over 12.5%, in just six short weeks. The "end" point, 09/30/2022, then, is not merely down 6%, but rather 18% from the intra-quarter peak, a much more dramatic shift, to be sure. Add to this the fact that the VIX Volatility Index ended the quarter up nearly 13%, and we can understand why the last quarter likely felt so much worse than it actually was.

With some clarity now in the rear-view mirror, how does that impact the forward-looking investment management advice we are giving to clients? In short, we are not changing the outlook or making wholesale changes to the investment strategy. Rather, we seek to apply discipline rather than luck to client portfolios. Since we cannot know the future, we do not think we can beat the market, but expect to be wise when it comes to short term needs, and avoid making emotional decisions for long term investors.

This is where EMH comes in. This theory generally asserts that the market is a projection of the economy and reflects all available information in its pricing. Since we believe all information is already accounted for in market pricing, we do not try to time the market to improve return. But, we can try to understand what new information might become available and how that might influence the market. (EMH suggests this too may be "priced in," but it can still be a lens to use.)

When thinking about the universe of new information that could be released to impact the market, the issue today is that it still seems the scale tips, unfortunately, in the direction of "bad news." This does not mean that we won't start to hear good news, we certainly hope we do, but, today it is hard to imagine what good news could come out that would be significant enough to shift the market. In bad and even less-than-good news, however, that is not the case. There is still along list of global, domestic, economic, and other items which could further spook the market. But, even if we see inflation come back into check, it is hard to think that this would be a dramatic enough change toward the positive. Could the Fed slow its interest rate hikes? Yes, but we know they are not going to reverse them. Could employment tick in the right direction, Yes, but not so much that we resolve all of the supply chain and service issues over night.

The bottom line is that we anticipate volatility to persist and do not foresee any obvious reason for the market to rally before the mid-term elections and likely the end of the year. At the same time we are already seeing corporations taking steps to protect their bottom lines, and believe these changes will bolster earnings in future quarters. For this reason, we continue to encourage clients to maintain relative allocations, keep adequate cash available for upcoming expenses, and invest excess funds in a disciplined manner.

Keep your seatbelts on for now!

-Open Door Financial

*See, We also recommend two books which discuss this, among other behavioral economic theories: The Undoing Project, by Michael Lewis; and, Thinking Fast And Slow, by Daniel Kahneman, who helped develop the field of behavioral economics and is responsible for the Peak-end rule theory.

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