We define volatility composure as a combination of past experiences and behavioral patterns that describe how an investor typically reacts to changes in the market value of his or her investments as well as overall changes in the value of the stock market. How will the individual actually behave–as opposed to how they think they will behave–when the stock market goes haywire (as it is doing now for the first time in quite some time)? How will the individual investor respond emotionally, and how do those emotions impact his or her behavior? During times of market volatility, investors that possess high volatility composure are more inclined to ignore market news and maintain their position regardless of what is transpiring day to day, while those investors that are low on volatility composure are more inclined to actively seek information (e.g., calling their advisor or checking the market frequently) and to take action (i.e., trading)–action that might not be consistent with their long-term financial goals.
Some of the behavioral components that determine volatility composure include an ability to stick to a long-term plan (i.e., a form of discipline), remaining calm even in chaotic situations (another form of discipline), and avoiding excessive worry when an element of their financial life feels uncertain. In our research volatility composure is positively related to traditional measures of “risk tolerance” (e.g., Grable & Lytton’s 1999 measure of risk tolerance), and is negatively related to how we view financial loss (i.e., so-called “personalization of loss”). But we also find that volatility composure is a separate and distinct component from other aspects of an individual’s experiences and personality that might influence investor behavior (e.g., judgment, risk personality, preferences). For example, volatility composure is a different animal than preferences for certain types of investments. You might love a good penny stock but at the same time have very little composure to watch it go to zero. Likewise, volatility composure is not the same as judgment; you may be extremely composed but at the same time be overly focused on short-term gains and losses.
Instead of focusing on specific cognitive/behavioral biases, our Investor Profile tool employs a broader behavioral approach, an approach that lends itself to guidance from the advisor to help the client improve critical behaviors over the long-term. As the Vanguard “Advisor’s Alpha” study asserts, the behavioral-guidance side of investment management can add significantly to annual portfolio returns. In other words, the guidance of a trusted advisor can help investors make better decisions and engage in better behaviors with respect to their investments. By understanding how we typically behave when the markets become choppy, we can create a plan of attack to neutralize and ultimately improve those behaviors.
Volatility composure is one of the five factors that contribute to an individual’s psychological risk tolerance that we measure using the Investor Profile tool. This tool was designed with the idea that understanding how individuals actually react to volatile market conditions can help to shape future behaviors and achieve improved long-term investment outcomes.
Grable, J., & Lytton, R. H. (1999). Financial risk tolerance revisited: the development of a risk assessment instrument. Financial services review, 8(3), 163-181.
Wood, R., & Zaichkowsky, J. L. (2004). Attitudes and trading behavior of stock market investors: A segmentation approach. The Journal of Behavioral Finance, 5(3), 170-179.
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