Regime changing - what should be the reaction?

Detecting regime changes may be one of the most important skills of any investor. You need to know when the world is changing to make effective investment judgments. There has been significant statistical work on measuring regime changes, but the more important issue is not when will they occur and but how will markets react to a regime change. Put differently, the skill of regime detection is knowing how markets will react to a change in regime.

Cade Massey and George Wu provides a good description on the causes of under and overreaction to regime changes in their Management Science work, "Detecting Regime Changes: The Cause of under- and Over-reaction". They develop a explanation that is called the system-neglect hypothesis. Their premise is that investors will primarily react to the signal that they observe such as information announcements and only secondarily to the environment that creates or produces the signal. We do not spend enough time thinking about the environment.

When the environment is unstable or going through changes, there will be a under-reaction to the information being transmitted. The focus is on the precise signals and not on the potential for change. Similarly, when there is a very stable environment, there will be a over-reaction to signals even when they represent noise.

Processing information is a combination of obtaining signals and determining the environment for this signal. If we think we know the environment to be very stable, we will place too much emphasis on the signal. When the environment is in a state of flux, we will under-respond to the ques we are given.