I recently read an article in Barron’s that discussed why rational investors may sell in heightened volatility. This intrigued me. If a rational investor were to sell based on downside volatility, wouldn’t they become an irrational investor? Not really. It’s not the selling that defines a rational or irrational decision; it’s the purpose behind the action.
The Rational Reason to Sell in Down Markets
If you are thinking it is rational to sell in down markets to protect from further loss, you are wrong. That is irrational behavior because you are assuming we can predict where the market will go. The rational sell in a down market to adjust their stated risk level, which is a function of volatility. It has nothing to do with where they think the market will go. Fear doesn’t drive their decision. It has to do with following a quantitative model.
Over the past several years, we have experienced very low volatility – especially last year. A quantitative model, that has a specific stated risk they want to maintain, will need to purchase a lot of stocks in a low volatility environment. When volatility spikes, as it has recently, they must pare back on stocks in order to maintain the stated risk level.
What Goes Up, Can Come Down
Quantitative and Risk Parity investments don’t change on a dime, so if heightened volatility persists, we can expect more selling from rational investors. This can be further exacerbated by leveraged investments that need to be sold to meet margin calls. And as we get persistent downward selling pressure, the irrational comes out in investors and many are influenced to sell low and get to safety.
The very same things that support long bull markets can change on a dime and work against us. The key is to remember that a security’s price is seldom indicative of its real value. A 20% pullback in the market may just be the folks that need to “de-lever” and “de-risk”. It results in high quality assets on sale. Unfortunately, many investors are too busy panicking that they can’t take advantage of the opportunity to buy low.