In today’s global, tightly integrated economy, extreme market drops are often created, or at least exacerbated, by investors’ collective trading behaviour. Often, irrationality is the underlying cause. Behavioural finance has discovered several psychological biases that prompt investors to act in, well, not particularly rational ways. One of the strongest psychological biases is Loss Aversion. Loss Aversion is the tendency that, in the Investors' minds, potential losses appear significantly larger than potential gains.
The TMT Loss Aversion index measures the extent to which the Investors are psychologically inclined to sell their investments at a loss because they fear further losses. The Loss Aversion is a self-enforcing mechanism; meaning that high losses on the overall market are actually created by the Loss Aversion of the market’s participants who rush to sell.
|Date||Index||Loss Aversion||Next Day Return|
For example, the gauge at -5% would indicate that, should the market over the next one day start dropping quickly, a daily drop of up to 5% is likely, as the Investors’ Loss Aversion prohibits the market from rebounding before this level.
In modern risk management, the most popular “quick fix” for quantification of extreme events is to simulate a fat tailed statistical distribution of market returns by dynamically adjusting the volatility parameter. Recent experience shows that this quick fix is unlikely to produce sustainable results. This is best illustrated by comparing the actual losses occurring on equity market indices to a 1% worst-case scenario generated though a dynamically adjusted volatility parameter, a procedure known as back-testing. Over significant time periods highlighted in orange in the below chart, the dynamically adjusted volatility approach leads to “worst case scenarios” which significantly understate the actual market losses.
The 1% extreme market drops (so-called "breaches") are expected to occur on between 2 and 4 days per year. Clearly the "quick fix" approach (orange) is not able to reflect the actual market behaviour, while the TMT Loss Aversion Index (green) performs much better.
In combination with other factors, the measurement of Loss Aversion using the TMT Index may be used to validate your investment strategy. Use the interactive charts below to check for yourself as to what extent the TMT Index level explains the future returns, outliers or volatilities.