Professor Explains Investor Mindset in Tumultuous Markets

But given recent trading volatility, it's clear that investors aren't convinced that we're in a bear market — or at least not yet. As Brad Barber, professor of finance at University of California, Davis, defines it: a prolonged bear market is characterized by little movement and low volume — essentially a long malaise in which investors "curb their enthusiasm." And while the market's been looking grim, volume is nowhere near muted. Yesterday, the New York Stock Exchange saw a record 7.38 billion shares change hands, while the Nasdaq posted record volume of 3.59 billion shares.

Barber, who specializes in investor psychology among other financial topics, says that in a bear market, or leading up to one, investors will often look worriedly at their portfolios, see stocks in decline and think, "I've got to do something." That can be a costly mistake, particularly if they sell their best-performing stocks in order to recognize gains and make themselves feel better. Even worse, Barber says, average investors are loath to sell their losers. After all, why reinforce a bad decision? Instead, they let bad picks ride their way down even further.

We spoke with Barber to get a better handle on what investors are thinking in these tumultuous times.

SmartMoney.com: What's been the typical investor psychology in the past week or so?

Brad Barber: When markets are in a bullish phase, when they're doing well, investors start trading and become fixated on the market. A lot of times they attribute their winning stock picks to their own skills, and not because the economy or market is doing well. So now, there's a lot less enthusiasm about trading speculatively. That's a good thing, because a lot of speculative trading hasn't been helpful. At the end of the day, volume tends to decline in bear markets. As the tumult is going on, of course there's high volume, but after a while you tend to get less participation in markets. There's an old Wall Street adage: Don't confuse brains with a bull market. That's the Cliffs Notes version of what I'm saying.

One of the things that happens in tumultuous markets is people want to rebalance their portfolios. But sometimes the best thing to do is do nothing. Buy and hold as if the market was doing well.

SM: But one argument that has been made is that some stocks are cheap now and represent a good buying opportunity.

BB: It runs counter to human nature, sort of like when you put your finger on a hot stove, you learn not to touch a hot stove. When the market goes down, you think, "I shouldn't be investing in stocks because I just got burned." But sometimes that's when there's a buying opportunity — in a down market.