A Retrospective Call for Introspection

Story Highlights:

• A year ago, the “Flash Crash” sent stocks on a volatile ride.
• The event also sent politicians and regulators scrambling for a “fix.”
• But in reality, the “Flash Crash” brings lessons that aren’t for regulators, they’re behavioral finance lessons for investors.

A year ago Friday, the dominant financial headline was an hour-long gyration in the equity markets commonly referred to as the “Flash Crash.” But with a year behind us, a factual perspective (see chart below) shows this is more of a non-event than was feared at the time. But nonetheless, the “Flash Crash” holds some important lessons for investors.

Source: Thomson Reuters, reflects S&P 500 total returns.

Friday, regulators and politicians opined far and wide the “Flash Crash” shows more regulation is needed—if nothing else, to protect the psyche and confidence of investors. We’re all for effective regulation. But there’s just no regulatory solution to correct all market volatility, and misguided regulation could easily yield broader unintended consequences. For example, regulators’ attempts to smooth out onion prices in 1958 led them to ban futures trading for onions. However, onion prices are now more volatile than other assets that do have futures trading—surely not the intended outcome.

So how to think about the “Flash Crash” in retrospect? It’s not cause for seeking a mythological regulatory cure-all, but rather a one-day course in behavioral finance with a very broad application. The lesson: You simply can’t approach markets seeking to prevent all possibility of negative volatility. This is a challenge for many investors who, after a terrible experience we don’t discount in 2008, seemingly see a crisis redux in any market negativity. But this psychological bend leads to far more errors than successes—and likely led some to sell at the height of the “Flash Crash” and miss the roughly 22% S&P 500 returns since.

Many investors miss the fact opportunity missed can be just as harmful to achieving investment objectives in the long term as money lost. If you’re an investor with goals or needs requiring equity-like returns for some, or all, of your portfolio, then missing potential positive returns means limiting the power of compound growth, which increases the risk of not reaching your long-term objectives. That’s a simple fact, but investors frequently struggle with it when volatility strikes.

If the “Flash Crash” impacted the way you approach investing, forget the chart above and look at the below.

Source: Thomson Reuters, reflects S&P 500 total returns.

It’s the same chart, minus the arrows and dates. Not so easy to pick out the “Flash Crash” is it? So why does the event still seem huge in the minds of some? Myopic loss aversion.

In general, investors tend to feel losses far more than they appreciate gains—even if the magnitude of the gain outweighs the loss. This psychological trap leads many to repeat investing errors, like acting out of fear when confronted with negativity. And that has a far broader application than just fleeting events like the “Flash Crash.”

Over the long term, investors falling prey to myopic loss aversion and acting on emotion has created as many (if not more) problems than a volatile day, week, month, or even a bad year. Now, there are times when it makes sense to exit markets, but those are rare relative to the times an equity investor should be in stocks. What investors seeking equity-like returns truly cannot afford is to be scared out of markets at the wrong time because of psychological biases rooted in a gut interpretation. Understanding how and why investors respond the way they do is an important step toward avoiding potential investing mistakes. And that’s a positive lesson brought by the “Flash Crash.”