The Market’s Reality Check

The stock market’s start in 2018 was a stark contrast to the smooth, record-breaking ride of 2017. After such an unusual year of strong returns, low volatility, and historically low interest rates, a flat market suddenly felt unsettling. But why? The answer lies in our expectations—and how market volatility reshapes them.

Barry Ritholtz at Bloomberg outlined some key anomalies that made 2017 feel so effortless:

• Above-average U.S. market returns

• Record corporate profits

• Strong overseas market performance, especially for U.S. investors

• Record-low market volatility

• Record-high political volatility

• Fed funds rates near historic lows

• Below-normal inflation

• Low bond yields

With the unwinding of short volatility trades, market volatility quickly returned. The initial drop in January led to a chain reaction—additional selling, the collapse of Credit Suisse’s short-volatility fund, and even more selling. As the dust settled, investors did what they do best: search for meaning where there isn’t any.

The Psychology of Market Reactions

To understand why market volatility feels so dramatic, we need to consider how human psychology plays into investing. Three major biases influence investor behavior:

• Apophenia – The tendency to see patterns or connections in random events. Investors often try to link market movements to economic or political events, even when the two are unrelated—especially during spikes in market volatility.

• Confirmation Bias – The habit of seeking information that supports pre-existing beliefs. In 2017, Trump supporters credited the “Trump Bump” for market growth, while critics blamed the “Trump Slump” for 2018’s volatility.

• Negativity Bias – The instinct to focus more on negative experiences than positive ones. Investors fear losses far more than they celebrate gains, leading them to overreact during periods of heightened market volatility.

The market doesn’t mix well with human emotions. Right now, investors are searching for meaning in every dip and rise, convinced that things are worse than they actually are. Awareness of these biases won’t eliminate fear, but it might help prevent impulsive decisions during uncertain times of market volatility.

The Volatility Opportunity

While uncertainty unnerves many investors, Wall Street traders are thriving in today’s volatile environment. Increased market volatility has fueled a surge in trading activity, especially in options and derivatives. According to research from Tabb Group and Hanweck, nearly 1.4 billion options contracts were cleared in Q1 2018—an all-time high and a 33% increase from the previous year.

Fund managers and institutional traders are actively hedging their risks through options trading—strategies tailored to navigate market volatility. A common approach involves buying put options, which act as an insurance policy against stock price declines. For example, if an investor buys Apple stock at $165 per share but fears it may drop below $150, they can purchase a put option at $150. If the stock falls, the put guarantees they can sell at that price. Most of these contracts expire unused, similar to life insurance policies, but the protection is often worth the cost when market volatility strikes.

Large institutions rely on these hedging strategies, but for most retail investors, a simpler approach is often the best: avoiding unnecessary trades and staying out of the market during periods of extreme market volatility. Unlike institutional investors, who manage massive portfolios that can shift the market with every move, individual investors have the flexibility to take a step back. Sometimes, the smartest play is simply not to play.

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