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.

As many of these economic reports come out, you are going to see volatility and high volume days. At some point, the announcements will calm down and the dirty laundry will all be aired, so to speak, and at that point we'll get to that lower level when people take a breather from the speculative trading.

SM: Do you suspect it's not just individual investors, but also many professional money managers who have been driven more by feelings than by information in the current market?

BB: On average, individual investors are more likely to be influenced by psychological biases than institutional investors. Many, but by no means all, institutions simply have more resources and trained professionals at their disposal than the average individual investor. These resources provide institutions a discipline that allows them to overcome psychological biases that might hurt performance. Having said that, there is no question that some individual investors display the discipline to overcome their psychological biases, while some institutions fail to do so.

SM: Can the findings from your 2006 paper about the effect of news on investors' buying behavior apply to today's market?

BB: Our basic point was that when you get a lot of press attention about a particular company, people tend to trade in that stock. I think that it would apply on the market level as well. When you have media reports saying [your portfolio may be in trouble], it may cause people to assess whether they have the right balance in their portfolios and that could lead to people actually doing something. I would guess people are more likely to reallocate their stock and bond investments during volatile markets than they are during calm markets.

The other thing that tends to happen as you trade individual stocks is that as stocks go down, people are more willing to sell their winning investments than their losing investments. We call that "prospect theory." Basically, when a stock goes up you think you made a good investment and you want to recognize those gains. You feel brilliant. But when a stock goes down, we can come up with a lot of excuses for why it did so. We tend to not sell that stock because we don't want to reinforce that bad decision. You hope that loser will come back and ultimately justify your original decision as a good one. So in a down market, people have a lot of losers. It's really a question of whether you should sell the winner. From a tax perspective, it makes more sense to sell your losers, not your winners, because with the loss, you can take a tax write-off.