“Our natural reaction is to sell after bad news and buy when news is good, thus indulging our fear and our greed. It’s an impossible strategy.” – Carl Richards
A recent study looked into the effects that the weather played on the trading patterns of institutional investors and how this influenced the overall stock market.
Surprisingly enough, this study concluded that, yes, weather can have an impact on investor mood and that this also impacts their trading patterns and ultimately the returns on the market on certain days. The authors of the study found that cloudy days increased the perceived overvaluation of the markets for both individual stocks and the market as a whole, as measured by the Dow Jones Industrial Average. This led institutional investors to make more sales on cloudy days. The increased weather-based pessimism resulted in a negative impact on the overall stock market on cloudy days because more investors were selling.
Another case of human nature messing with the markets.
And remember, this is the supposedly “smart money” institutional investors. They (we, since I’m one of them) have the same cognitive biases as everyone else investing in the markets.
There is an old joke that the only reason that we have economists is to make the weatherman feel better about his predictions, but I don’t think trading based on the weather is the point here.
The conclusion that you should draw from this study is the fact that investor risk tolerance can change from day to day for any number of reasons. The reason this is important to acknowledge is because your appetite for risk will change over time based on a number of factors even if your circumstances stay exactly the same. And it’s not only the weather that can affect your mood. The current investment landscape, the movement of the markets, how you feel about it at the time, the changes in the economy, your employment situation; these factors all play a role in shaping your current feelings about how comfortable you are with taking on risk.
Legendary investor Howard Marks has a great take on this subject:
In my opinion, the greed/fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk. The academics consider investors’ attitude toward risk a constant, but certainly it fluctuates.
When things are good, you’ll feel like you should be taking more risk. When things are bad you’ll feel like taking on much less risk. That’s how human nature works. It’s easy to let the constant fluctuations in the markets cause you to make irrational decisions based on the ebb and flow of your mood swings.
That’s why creating an investment policy statement (IPS) is extremely important to remind yourself of your stated goals, risk tolerance and time horizon. A rules-based approach will allow you to keep an even keel (even when it’s cloudy out).
Having everything down on paper to remind yourself to keep a level head when all around you people are losing it can make all the difference between letting the cycle of fear and greed take over and following through with your investment plan.