By LARRY SWEDROE
While there is always uncertainty in the outlook for the economy and financial markets, a confluence of events has increased the uncertainty to high levels. The following are among the events that increased investor ambiguity:
COVID-19 caused disruption of supply chains, leading to rising prices. It also led to the “Great Retirement”, resulting in the tightest labour market we have ever had, with almost two jobs posted for every unemployed person and an unemployment rate of only 3.6 percent — leading to pressure on wages, further fuelling inflation.
Massive fiscal and monetary stimulus in response to the COVID crisis not only fuelled demand while supplies were constrained but pushed the debt-to-GDP ratio to in excess of 100 percent — creating concerns about the impact on future economic growth.
Russia’s invasion of Ukraine disrupted energy and food supplies, pushing prices higher.
Government policies to discourage carbon-related energy production and distilling capacity, combined with the need to transition to greener forms of energy, have negatively impacted supplies, increasing inflationary pressures.
Risk versus uncertainty
There is an important distinction between risk and uncertainty (ambiguity). For example, when we roll dice, we can calculate precisely the odds of any outcome. And using actuarial tables, we can calculate the odds of a 65-year-old living beyond age 85. Uncertainty exists when we cannot calculate the odds. An example would be the uncertainty of another attack such as the one we experienced on September 11, 2001. Unfortunately, investors often confuse the two concepts. The following is an example of confusing risk with uncertainty.
An insurance company might be willing to take on a certain amount of hurricane risk in Dade and Broward counties in Florida. They would price this based on approximately 100 years of data, the likelihood of hurricanes occurring, and the damage they did. But only a foolish insurer would place such a large bet that if more or worse hurricanes occurred than had previously ever been experienced, the company would go bankrupt. That would be ignoring — that the future might not look like the past.
Individuals often make a similar mistake, causing them to decide on an equity allocation that exceeds their ability, willingness and need to take risk. The mistake is that when economic conditions are good — when investor sentiment is high — individuals tend to view equity investing as risk, where the odds can be calculated precisely. Their perceived “ability” to estimate the odds leads to overconfidence, an all-too-human trait. That drives up equity prices, which drives down the equity risk premium demanded by investors. However, during crises, investors’ perception about equity investing shifts from one of risk to one of uncertainty. We often hear commentators use phrases like “there is a lack of clarity". Since investors prefer risky bets to uncertain bets, when the markets begin to appear to investors, the risk premium they demand rises — and that is what causes severe bear markets.
Dimitrios Kostopoulos, Steffen Meyer and Charline Uhr, authors of the study Ambiguity and Investor Behavior, published in the July 2022 issue of the Journal of Financial Economics, investigated the time-varying effect of market-based ambiguity on the trading activity and risk-taking on a large sample of individual investors. They began by noting that prior research had demonstrated that: Investors tend to be ambiguity averse; ambiguity is distinct from the equity risk premium; and ambiguity affects asset allocation decisions—the higher the ambiguity aversion, the lower the stock market participation of individuals.
For their measure of ambiguity, they used the volatility of the EURO STOXX — whereas the VSTOXX measures the over the following 30 days, the V-VSTOXX measures the about the future risk over the following 30 days. They matched the V-VSTOXX to the trading records of more than 100,000 individual investors of a large German online brokerage. Their final data sample excluded investors who relied on the advice of financial advisers (they were interested in household financial decision-making, not financial adviser suggestions) and covered the period March 2010-December 2015 and more than 23 million trades. Following is a summary of their findings:
Consistent with prior research findings, 58.7 percent of investors were ambiguity averse, 12 percent were ambiguity neutral, and 29.3 percent were ambiguity seeking.
Ambiguity shocks lead investors to trade more and to trade out of risky securities — high ambiguity was associated with more logins and more trading (both statistically significant at the 1 percent confidence level).
Ambiguity shocks caused investors to decrease their exposure to the security market by trading out of stocks and similarly risky assets. This effect did not reverse within the following 10 days — ambiguity shocks caused investors to reduce risk or even exit the market entirely.
The ambiguity effect was stronger for ambiguity-averse investors — they were 4.5 times more vulnerable to innovations in ambiguity than the average investor.
Ambiguity-seeking investors, in contrast to ambiguity-averse investors, increased their exposure to risk when they experienced ambiguity shocks.
Both ambiguity and risk are conceptually different from sentiment.
Investor sentiment appeared in both high and low ambiguity periods. However, in high ambiguity periods, individual investors were more prone to sentiment. The differences in sentiment between high and low ambiguity periods was statistically significant and economically large. This is important, as Malcolm Baker, Jeffrey Wurgler and Yu Yuan, authors of the study Global, Local, and Contagious Investor Sentiment, found that investor sentiment was negatively correlated with future returns.
Risk-taking of individual investors was significantly driven by innovations in ambiguity and not in risk — the ambiguity-return trade-off was stronger than the risk-return trade-off.
Their results were robust to various measures of ambiguity, including the dispersion of forecasts of professional forecasters and financial media measures of financial policy uncertainty.
Their findings led Kostopoulos, Meyer and Uhr to conclude: “When the aggregate ambiguity in the market is high, investors have a hard time assessing investment opportunities and future security outcomes. Accordingly, they seem to feel less certain about their investments and seem to hence require updates on their portfolios more often. Therefore, they log in more frequently in these periods. Moreover, when the aggregate ambiguity in the market is high, individual investors not only focus more on their portfolios, but they also seem to adjust their portfolios, as they then trade more.”
Investor takeaways
Investing in equities is always about uncertainty, not risk. In fact, that is exactly why the equity risk premium has been so high — investors demand a large risk premium to compensate them for taking uncertain “bets”. Those investors who recognise this will avoid the mistake of taking more risk than they have the ability, willingness or need to take, giving themselves the greatest chance of staying disciplined, adhering to their well-thought-out plan. That plan should anticipate the virtual certainty that bear markets will occur and that they are unpredictable in terms of when they will start, how long they will last, and how deep they will be. That understanding will help avoid the mistake of letting their stomachs, and not their heads, make investment decisions.
I have yet to meet a stomach that makes good investment decisions, and the historical evidence is clear that dramatic falls in prices lead to panicked selling as investors eventually reach their GMO point — their stomach screams “Get me out!” And selling begets more selling. Investors have demonstrated the unfortunate tendency to sell well market declines have already occurred and buy well rallies have long begun. The result is that they dramatically underperform the very mutual funds in which they invest. The stocks they buy underperform after they buy them, and the stocks they sell go on to outperform after they are sold.
Unfortunately, for those investors who sell and get out of the market “just until things become clear again” (investors begin to treat equity investing again as risk instead of uncertainty), there is never an “all clear” signal that will let them know it is safe to buy again. Once you sell, it is almost impossible to get it right again because so much of the market’s gains come in very short bursts that are impossible to capture unless you follow the advice of Charles Ellis, author of Winning the Loser’s Game: “Market timing is unappealing to long-term investors. As in hunting deer or fishing for rainbow trout, investors have learned the importance of ‘being there’ and using patient persistence — so they are there when opportunity knocks.”
Picture: James Frewin via Unsplash
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