That uncertain feeling

Uncertainty also stimulates big moves because traders react to it in an unusual way. Work done by Daniel Ellsberg in the early '60s suggests that, faced with ambiguity, most people try to minimize possible losses. But there’s considerable evidence that many traders, by contrast, deal with ambiguity by trying to maximize potential gains—thus the familiar dictum that volatility creates opportunities.

In part, this is because it’s the job of traders to trade. But it’s also because market professionals appear to be chronically overconfident. A 2005 study of traders and investment bankers at two large banks, for instance, found that they significantly overestimated their knowledge of finance and the accuracy of their predictions. A 2002 survey of experienced foreign-exchange traders found, similarly, that they were far more sure of their market forecasts than performance justified.

Overconfidence matters, because it can encourage excess trading. A study of individual investors by the economists Markus Glaser and Martin Weber, for instance, found that investors who thought more highly of their ability also traded more.

What’s worse, the effect seems to be magnified in times of uncertainty. The business-school professors Itzhak Ben-David and John Doukas, in a study based on 20 years of trading by institutional investors, found that when there’s a profusion of “ambiguous information” about stocks investors trade more frequently, not less. And they do so even though, on average, they end up losing on their trades.

Oddly, then, the very things—uncertainty and lack of information—that might seem to make less trading and smaller bets advisable are pushing stock-market traders in the opposite direction. And this tendency is exacerbated by the fact that we are in a down market: The S&P 500 has fallen almost 14 percent this year.

Mebane Faber, of Cambria Investment Management, recently did a study showing that, historically, volatility is significantly greater in down markets than in up ones. One likely reason is that traders, like gamblers, often find themselves “chasing losses”—if you’ve lost a lot, it’s tempting to make big bets, in an attempt to get your money back.

So far, all this volatility has had little lasting effect on the value of the stock market. But in the long run volatility is a very bad thing, because it makes ordinary investors less inclined to trust markets. As a corrective to the recklessness of recent years, this might seem desirable, but too much risk aversion makes capital more expensive for everyone from businesses to homeowners, and the economy less dynamic.

Once we get a clearer idea about the future, today’s volatility should diminish. But for now we’re stuck in a Yeatsian market: the best lack all conviction, while the worst are full of passionate intensity. Let’s hope the center can hold.

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