There are many reasons for this impressive volatility, however an underappreciated factor is investor psychology. When times are good, the pendulum of investor psychology swings towards greed, credulousness and risk-tolerance. Investors assume that the good times will continue on forever, because “this time it’s different”, and pay prices that assume blue skies forever because they can’t remember the last time it was a rainy day.
Inevitably, storm clouds appear, and the pendulum swings towards fear, incredulity and risk-aversion. Investors rush for the exit, caring more about cutting their losses than taking advantage of the hysteria of the market. Investors sell at prices that assume that we’ll never see a blue sky again, and previously overpriced investments become bargains.
Warren Buffett once wrote that investors should be fearful when other are greedy and greedy when others are fearful. This does not come naturally to us, as our evolutionary psychology was formed in an environment where conformity and unity was necessary for survival, making contrarian behaviour uncomfortable. However, contrarian investing is the best way to buy low and sell high, whilst following the herd is an express lane to buying high and selling low.