A single issue for an island nation sparks financial market panic, or not.
Economic theory generally assumes that investors are rational and that stock and bond prices accurately reflect all current information about these investments. Events like Britain’s June 23rd vote to leave the European Union often raise doubts about these theories.
Fortunately, economic research can still help explain these big price moves, and current market indicators suggest the price moves are not that big after all. Markets may not be as crazy as we perceive them to be.
Behavioral finance is a branch of economic research that includes psychological studies of investor behavior, such as attitudes towards risk and belief about probabilities. First, our “pain” from losses exceeds our “joy” from gains. Translating this to investment choices means that we generally take on more risk only after making good gains, and stop taking risks altogether when occurring losses. This tends to exacerbate these same trends, making the market more volatile in the short-run than it would be otherwise.
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A second psychological factor is our beliefs about probabilities. When we witness an event that rarely occurs, we overreact.
So behavioral finance teaches us to expect excessive short-term trends and overreactions to events like the British vote. But how much volatility is too much?
A widely cited measure of stock market volatility and risk is the CBOE Market Volatility Index, or VIX. The index reflects the cost of hedging risk through the sale or purchase of option contracts on the largest U.S. stocks. This cost rises when prices move dramatically in one direction or another, reflecting greater uncertainty over what their price will be in the future.
The VIX rose to 25 after the British vote, but quickly fell back to 15 by the end of June. Both these levels are not far from index’s long-run norm of 20.
Two key measures of stock values are also not out of line. Stocks in the Dow now sell at an average rate of 19 times past earnings and yield over 2.5 percent from dividends, just above the long-run average for both.
The Brits may have surprised us, but the market’s not crazy.
Peter Crabb is professor of finance and economics at Northwest Nazarene University in Nampa. firstname.lastname@example.org. This story appears in the July 20-Aug. 16, 2016 edition of the Idaho Statesman’s Business Insider magazine. Click here for the daily Statesman e-edition, including Business Insider (subscription required).