Sentiment affects Stock markets

Every fall, 5%-to-10% of the population gets a diagnosable case of seasonal affective disorder (SAD). Another 20% get the winter blues. The result? You have a bunch of depressed people trying to decide how to invest.

Every investor’s risk tolerance seems to drop in winter and people who are prone to seasonal disorders experience a much bigger drop.

Depressed people take less risk and psychologists have proven people can’t make decisions without emotions. So while it’s all very well for economists to apply a view of rationality and efficient outcomes to the investment world, the reality is that without emotions people can’t choose which pair of pants to wear, much less decide between treasuries or equities.

Bad news synchronizes people, and there are three kinds of waves in sentiment:

  • Long periodicity waves: the rise and fall in the business cycle
  • Annual cycle: the seasonal cycle of summer and winter
  • News-driven cycles: frightening world events like the Japanese nuclear disaster or the Norway shootings

How can you guide clients?

For advisors, it’s best to focus on long-term goals and de-emphasize immediate needs. Help clients understand they
can’t make good decisions if they’re unstable.

How many weddings in Las Vegas were the result of momentary euphoria and sorely regretted later? It’s the same thing with investing. You need to understand that for six months, your clients’ risk tolerances change. They’re not the same people they were when the sun was out. They might need to forgo some upside to avoid the nervousness of the downside.

Does this mean we can “game the market”?

Yes, but only by taking on risky positions your clients are likely trying to unload. Every year, prices fall in September or October. It’s probably no coincidence that all the big market crashes happen in those months.

If your clients’ aim is to beat the system, then advise them to do their levering up in October, rather than April. Rewards won’t be as great in the spring because people are resuming risky positions and bidding up prices. If you have a price drop in summer months, it’s because there’s something really bad happening.

If a piece of news scares you, it probably does the same to other people. Expect prices to decline, knowing full well that as soon as the appetite for risk normalizes, asset prices will jump back up. If your clients have the stomach for short-term, high-frequency price movements, you can help them take advantage of this situation. But make sure they have deep pockets if you attempt this strategy. Bad news tends to follow bad news.

Originally published in Advisor's Edge