• Investors routinely underperform their own portfolios because behavior, not market returns, drives results

• Strengthening financial literacy is a highly reliable way to shrink the behavior gap

• Professional guidance can help investors stay disciplined when emotions threaten long‑term performance

Predicting financial markets is tough, especially in the short term, but the behavioral habits of the average investor are remarkably consistent in reducing performance. Fortunately, there’s a straightforward fix for some of the biggest behavioral-risk challenges: strengthen investment literacy.

Identifying the problem is relatively straightforward: reacting emotionally to market volatility, for example, can lead investors to panic and make poor decisions. Where things get tricky is adjusting behavior in ways that actually support long‑term financial objectives.

But there’s no debate about the underlying issue. Numerous studies over the years point to an ongoing and uncomfortable truth: investors consistently underperform the very investments they hold.

The issue isn’t flawed portfolio design, which is relatively easy to resolve, particularly for the most-misguided investors. But even the best‑constructed investment strategy will suffer if erratic and ill-advised behavior creates a gap between a portfolio’s return and the lower performance investors actually earn due to poor decisions.

DALBAR, Inc. has been quantifying this so‑called behavior gap for decades. Although the investor penalty rises and falls in any given year, it’s reliably persistent. For 2024, the consultancy reports the “second largest performance gap of the past decade,” with the average equity investor trailing the S&P 500 by more than eight percentage points. The gap narrowed sharply to 72 basis points in 2025, but the average investor still lagged the market.

The behavior gap is also conspicuous for fixed‑income investors, widening to nearly five percentage points in 2025.

Morningstar’s research finds similar results. A recent review of the data reports: “Over the past 10 years, the average dollar invested in US mutual funds and exchange‑traded funds earned 1.2% less per year than what those funds returned during the same period.”

Closing the gap — if not outperforming — is the goal, and the first step is recognizing that behavior is usually far more important than investment selection on average. A recent study by an independent financial researcher underscores how costly emotional decision‑making can be.

“The typical investor suffered a loss of more than 50% of their investment potential because of their own emotional choices rather than market downturns or high costs or wrong investment choices,” advises “Beyond Alpha: Why Financial Education and Behavioral Discipline Outperform Investment Selection in Long‑Term Wealth Management.”

Using DALBAR data, the author adds: “This is not an anomaly. It is the norm.”

Another study a few years ago found that financial literacy is the lowest among the young, based on testing on three questions related to interest, inflation, and risk. “Only 14% of those under age 35 answered all three questions correctly,” according to the FINRA Foundation’s 2021 National Financial Capability Study. “Young people’s financial literacy knowledge lags that of older adults. Nevertheless, less than half of those 66 and older were able to correctly answer the Big Three.”

Focusing on financial education as a solution should be the new norm, the “Beyond Alpha” paper concludes. While this advice has always been true, it matters more than ever for several reasons. One is the surge in the Great Wealth Transfer — an estimated $84 trillion moving from Baby Boomers to younger generations in the years ahead.

Three additional factors raise the stakes for developing financial literacy, according to the study:

• Investor demographics are shifting: Women, Millennials, Gen Z, and growing numbers of minority investors are accumulating more wealth, yet many still face gaps in financial knowledge and access to quality guidance.

• Traditional portfolio management is increasingly commoditized: Low‑cost index funds and other innovations have erased cost and access advantages, making behavioral coaching and client education the true differentiators.

• Regulations are raising the bar: Fiduciary standards increasingly emphasize delivering maximum client value, and evidence suggests behavioral coaching can help meet that requirement — meaning advisors who ignore it may risk falling short of evolving regulatory expectations.

Changing human behavior may be challenging, but the benefits of enhancing financial literacy have been shown to improve investment outcomes. A 2014 study in the Journal of Economic Literature found that taking the time to improve financial savvy leads to smarter long‑term decisions and stronger returns.

Not every investor has the time or inclination to self‑educate on the finer points of managing behavioral risk — and that’s exactly where professional guidance becomes invaluable. A skilled advisor can help an investor bridge the gap between good intentions and disciplined execution, potentially turning financial knowledge into lasting financial results.

One of the best financial moves you can make isn’t outsmarting Wall Street—it’s using financial literacy to outsmart your own instincts.

• The 10‑year yield is near the top of its recent range, raising pressure for stocks

• Relatively elevated “risk‑free” Treasury yields are tougher competition for equities

• The latest rise in rates tilts the near‑term risk outlook for stocks toward caution

The 10‑year Treasury has rebounded to the upper edge of its recent range, keeping rate pressure front and center for equity sentiment. Stocks remain steady near record highs, driven by expectations that investment in artificial intelligence and tech will continue to provide earnings support. Yet the benchmark Treasury yield’s elevated level leaves the market waiting for the next catalyst—whether fresh inflation data, a shift in Fed expectations, or a geopolitical jolt—to determine if rates continue to move higher or begin to ease and give risk assets some breathing room.

Treasury yields are one of many factors that shape how Wall Street weighs the near‑term outlook for stocks versus bonds, but relatively extreme levels in bond‑market rates vs. the recent past can resonate. When the 10‑year rises, “risk‑free” income looks more attractive, making bonds a stronger competitor to equities. When yields fall, the allure eases, arguably pushing investors toward stocks. In effect, the 10‑year can act as a signal for when conditions appear attractive for leaning into growth (equities) or shifting toward safety (bonds).

The relationship isn’t perfect, but it does tend to rhyme through time. One way to monitor the link between the asset classes is to track the 10‑year yield in terms of its current level vs. its trailing 200‑day window. History suggests that when the benchmark rate’s relative valuation is elevated, the increase implies that the potential for equity volatility may rise. That dynamic was highlighted by TMC Research in previous updates – in mid-February 2025, for example, which showed the indicator approaching levels that have historically aligned with a more cautious equity backdrop.

On that basis, the recent run‑up in the 10‑year yield, in both absolute and relative terms, could be a new headwind for stocks. Equities tend to outperform bonds by a wide margin in the long run. But the periodic opportunity in Treasuries to earn a relatively high share of the long‑term return that stocks typically deliver—while taking far less risk—creates robust competition. When investors can lock in a strong, “risk‑free” payout, the appeal of taking on stock‑market volatility diminishes, if only on the margins.

Bonds are never a replacement for stocks, especially when designing an asset‑allocation strategy for medium‑ to long‑term horizons. But as the chart above suggests, the expected risk for stocks in the near term is not static; it ebbs and flows for a variety of reasons.

One is the degree of influence the bond market exerts through current yield, which can be “locked in” by buying and holding an individual fixed‑income security to maturity. Based on the chart above, the case for viewing the latest rise in the 10‑year as a meaningful, if still debatable, challenge to equity sentiment appears to be strengthening.

• The Federal Reserve faces crosscurrents as geopolitical shocks and fiscal strain threaten to reignite inflation

• Diverging inflation gauges blur the policy signal just as decisions grow more consequential

• Markets are split, with some hinting at tightening while others still reflect caution

The outlook for the Federal Reserve’s mandate to control inflation isn’t getting any easier.

The Middle East conflict is escalating again, creating new shipping bottlenecks for energy exports from the region, which could delay—and possibly reverse—the recent disinflationary impulse in the U.S. economy that had appeared set to soften pressure on the Fed to raise interest rates.

Another source of uncertainty is the government’s persistently large fiscal deficit, which risks becoming inflationary as heavy borrowing keeps upward pressure on demand, interest rates, and the overall price level.

Adding complexity to the outlook is the government’s plan to revise how the Personal Consumption Expenditures (PCE) Price Index—the Fed’s preferred inflation gauge—is calculated starting with the September report. The upcoming methodology change reflects the reasonable view that spending patterns and the structure of the modern economy have shifted enough that the index needs updated weights and improved measurement to give policymakers a clearer read on underlying inflation pressures. Nonetheless, the adjustment could be viewed as controversial at a time when current inflation readings remain well above the Fed’s target and rate hikes may be near.

Fed funds futures continue to price in high odds that the central bank will leave its target rate unchanged at next week’s policy meeting (July 29). By year-end, however, futures anticipate one or more hikes.

TMC Research’s Fed Funds Model suggests that policy has recently shifted to a modestly dovish stance, crossing into that terrain in May for the first time in more than three years. The switch implies a case for lifting the current 3.50%–3.75% target range to maintain a neutral stance that balances the Fed’s goal of keeping inflation steady or pushing it lower while providing the economy with sufficient liquidity to sustain a growth bias.

Achieving the central bank’s dual mandate—minimizing inflation and maximizing employment—is always tricky, and may be particularly difficult for the remainder of the year. Inflation is being pushed around by forces largely beyond the influence of monetary policy—renewed Middle East conflict, energy‑supply risks, shipping disruptions, and persistent fiscal deficits—while the labor market remains firm enough to resist cooling. That combination leaves the Fed trying to restrain price pressures without derailing employment, a balancing act made tougher by shocks that policy can’t easily offset.

The Fed is also receiving mixed signals at a challenging moment for policymakers: core PCE’s one‑year rate has been drifting higher, the core Consumer Price Index eased in June, and the 16% Trimmed Mean CPI—a measure Chair Warsh has praised as a cleaner read on underlying inflation—is hovering near the Fed’s 2% target. That divergence muddies the policy picture, forcing officials to decide whether inflation is re‑accelerating or simply settling into a slower, more stable trend.

The bond market has been flirting with the possibility that a Fed rate hike is near. The 2‑year Treasury yield—widely viewed as a market‑based proxy for rate expectations—is trading above 4.2% this week, well above the Fed’s current 3.50%–3.75% target range, implying that investors expect a hike.

Short‑term market rates, however, suggest that tightening isn’t imminent, per the chart below, which highlights several rates that are sensitive to policy‑bias expectations. A decisive move upward in these rates from current levels could be an early sign that liquidity conditions are shifting to accommodate an increase in the Fed’s target rate, proxied by the Effective Fed Funds Rate (red line).

Despite the relative calm in the bond and rates markets, the next several policy meetings could be more complicated than usual to navigate. Part of the challenge is a rising skepticism about the accuracy of economic data—doubt that could be amplified by the government’s planned September change in the PCE inflation methodology.

As former Federal Reserve and White House economist Claudia Sahm wrote last week: “If we do not all agree on the yardstick, then a commitment to price stability is nearly meaningless.”

Fed Chairman Warsh has made several hawkish comments since taking the helm in May. In what may become his signature statement, he emphasized that the Fed would have “no tolerance” for persistently elevated inflation above the 2% target.

Yet some critics charge that he has not outlined how he intends to achieve that goal or whether PCE remains the formal yardstick. The Fed chief has criticized core PCE in Senate testimony as a “rough swag as to what was going on” with prices. “We don’t have to do a rough swag any more.”

His gray‑zone commentary concerns some Fed watchers, who argue that the lack of clarity, intentional or not, may make the central bank’s job tougher as it tries to keep inflation near its target.

Sahm asserts that “Redefining inflation is not the way to achieve price stability.”

The crucial question is whether the bond market will interpret the shifting metrics, mixed signals, and geopolitical shocks as a sign that the Fed’s inflation‑fighting credibility is strengthening—or slipping.

• Investors often flee to safety fast, but crawl back to risk slowly

• Fear tends to drive the trade, not math

• Staying safe too long can cost you the recovery

One of the biggest threats to long‑term investing isn’t a volatile market or high fees, but it can be the way our brain reacts to them.

While we like to think of ourselves as rational, humans are hardwired to react emotionally to financial highs and lows — a vulnerability generally known as behavioral risk. When investors panic-sell during market drops or chase hyped-up trends at their peak, they run the risk of locking in losses and dragging down their returns. Ultimately, managing your own behavior and sticking to a plan can matter far more to your lifetime wealth than trying to outsmart the stock market.

There are various dimensions of behavioral risk, and perhaps the facet with the highest stakes arises during periods of extreme market volatility. A recent study adds crucial insight by demonstrating that investor behavior is itself highly volatile during periods when “safety” is in high demand. The analysis highlights several pitfalls that emerge when market stress is elevated, according to “Risk Perception under Uncertainty: A Behavioral Analysis of Safe-Haven Asset Return Responses,” published last month in the Journal of Research in Economics, Politics & Finance.

One of the study’s main findings is that investor risk is not a static, mathematical formula, but a dynamic, psychological reaction. That contrasts with traditional finance models, which treat risk as a two-way street and assume, for instance, that when market uncertainty rises by 10%, safe-haven prices go up by a matching 10%, and when uncertainty falls, they drop by the same degree. This paper shows that investor behavior is, in fact, highly asymmetric (unequal).

The research finds evidence of what might be called a panic premium, the extra cost added to certain assets during times of widespread fear or uncertainty. Markets can react violently to bad news, causing safe-haven prices to jump quickly. But when the dust settles, those prices don’t come down nearly as fast, because human fear lingers. If you buy during the panic, you may end up locked into an inflated price.

Investors react far more aggressively and persistently to increases in uncertainty — driven by loss aversion and panic — than they do to decreases in uncertainty. When a crisis hits, investors overreact and pile into safe assets, driving prices up rapidly.

The flip side of this behavioral pattern is that the recovery is slow. When the crisis ends and uncertainty falls, investors do not sell off their safe havens at the same speed. Fear lingers, causing safe-haven prices to remain elevated long after the actual danger has passed.

If you buy defensive assets during a crash, you probably aren’t solving a calculated math problem to optimize your expected payoff. Rather, you’re paying a premium for a “psychological anchor” that soothes your anxiety and stops the emotional pain of watching your portfolio drop. Contrast that with the standard financial-textbook assumption that investors are rational and will make logical, cold-blooded decisions, even when a portfolio has quickly lost 20%. In reality, biology takes over.

One lesson is to build a structured portfolio before the storm hits — often a more reliable way to protect yourself from your own inevitable, fear-driven decisions. Putting clear rules in place on how a portfolio will be managed through time — before a crisis strikes — is also prudent.

As the study notes, “The investment decision of an individual can be affected by psychological variables like uncertainty, anxiety, and fear... The helpfulness of the concept of rationality is limited in times of turmoil.”

This research highlights a subtle but consequential risk for investors: the loss-averse instinct that sends capital rushing into safe havens during spikes in market volatility, policy uncertainty, or geopolitical tension does not reverse with equal speed once conditions calm down. In short, investors tend to de-risk fast but re-risk slowly, if at all.

For an investment portfolio, this behavioral lag can translate into a tangible opportunity cost: capital that stays parked defensively out of lingering anxiety, rather than being redeployed once risk genuinely subsides, misses out on the recovery and growth phases of the market cycle. Over time, this pattern of overstaying in “safety” can quietly erode long-run returns relative to a more risk-tolerant, timely reallocation strategy — turning a rational, protective impulse in the moment into a source of underperformance in the long run.

None of this means that periodic adjustments to risk exposure is inherently a mistake. Tilting toward a more defensive asset allocation during periods of genuine stress is often a sound and necessary part of managing a portfolio through time. The problem isn’t the instinct to seek safety; it’s the tendency to stay there long after the original rationale has faded.

The real takeaway is that risk management works best as a deliberate, pre-planned process with well-designed rules rather than a reactive one driven by lingering fear. Investors who build a sound framework in advance — with defined triggers for both scaling into and out of safe havens — are better positioned to manage risk through time without falling into the trap of chronic overcaution.

Done well, risk management remains one of the most valuable tools an investor has; done reactively, it can quietly become one of the costliest.

• Passive tends to work inside an asset class, while customizing may matter more for investing in several markets

• Investors face finite time horizons and various behavioral challenges

• Risk‑tuned asset allocation could potentially deliver steadier, more “livable” outcomes

The case for indexing is well‑established, supported by academic and empirical research. But while there’s a strong case for passive investing within an asset class, in our view the argument weakens—if not breaks down—when the focus turns to multi‑asset‑class portfolio strategies.

There are several reasons why asset allocation may reasonably be customized, which is to say intentionally designed to deviate from a passively managed, market‑value‑weighted strategy. One of the more compelling factors: the time horizon for a passive asset‑allocation strategy is optimal, in theory, only for the average investor with an infinite time horizon. No individual investor matches that profile, which lays the groundwork for customizing asset allocation for a real‑world portfolio.

The apparent contradiction between favoring passive strategies within an asset class vs. customizing strategies that use several asset classes isn’t inconsistent upon closer inspection. Markets are relatively efficient (or at least hard to beat) within a particular asset class. The most compelling example is large‑cap U.S. stocks, as S&P Global’s periodic updates remind. A recent update reports:

Of all active large‑cap U.S. equity funds measured, 79% underperformed the S&P 500 in 2025, worse than the 65% rate observed in 2024 and the fourth‑worst year for active large‑cap managers over the 25‑year history of the SPIVA Scorecards.

Using index funds to capture asset class beta is defensible, if not compelling, but the rationale doesn’t always transfer to asset allocation for reasons related to risk management, particularly for individual investors. Saving for retirement, planning for college expenses, and similar goals are bound up with finite time horizons, even if they run for several decades. That’s a mismatch with a market‑value‑weighted asset‑allocation strategy that, in theory, would hold all investable asset classes and never rebalance.

A passive asset‑allocation strategy may be tough to beat over very long stretches of time, but investors have financial needs in the short term that require liquidating investments. There are also behavioral factors in play that raise the value of “livability” in portfolios. The short‑run volatility that a passively managed asset‑allocation strategy may exhibit could be a bridge too far for some—perhaps many—individuals. The ideal investment plan for the long haul is worthless if market volatility triggers a flight‑to‑safety decision during the depths of a bear market.

Managing risk, in other words, is necessary, but in our view, it tends to work best at the asset‑allocation level. One reason: while markets tend to be efficient within asset classes—which implies indexing is preferable in this context—cross‑asset‑class efficiency is often substantially lower.

Some research hints at the possibility that trading frictions can be higher and capital flows slower between asset classes at certain times compared with transactions within asset classes. One explanatory theory is that most market participants are highly specialized in a given asset class, in contrast to the smaller group of generalists who focus on reallocating capital across markets, such as stocks, bonds, real estate and commodities.

A contributing factor may be related to various behavioral biases and industry constraints. For instance, home bias—a tendency to invest a disproportionately high share of a portfolio in one’s domestic market—may play a role. Consider that U.S. equities in 2024 represented nearly half of global stock‑market capitalization, according to SIFMA, a financial‑industry trade group. Tracking a passive mix of global stocks translates to a 50/50 allocation. Most U.S.‑based investors with international equity exposure are probably holding substantially lower levels of foreign stocks.

Capital bottlenecks could also play a role—capital flows across borders, although streamlined in recent years, are still less efficient than money management within borders.

Another dimension is complex macro dynamics, including geopolitical risk and manipulated foreign‑exchange values, which also reduce cross‑border and cross‑asset allocation efficiency relative to single asset classes within a country. But therein lies a degree of opportunity, since lower market efficiency raises the potential for mining portfolio alpha through tactical asset allocation and related strategies.

Keep in mind that alpha can be defined in terms of risk‑adjusted return. That’s a key point, since individuals don’t have 50‑year investment windows. Retirement dates, college funding, home purchases, and health‑related expenses create fixed deadlines. A deep drawdown close to one of those deadlines can permanently impair outcomes because there isn’t enough time for markets to recover.

An added complication: humans are not rational compounding machines. They are emotional, pattern‑seeking, and loss‑averse. Risk management can reduce the emotional triggers that activate these biases. Shallower drawdowns, for example, mean fewer panic decisions. More stable return paths reduce temptations to chase performance.

Customizing an asset‑allocation strategy using low‑cost index funds tends to be the more effective path for managing risk and designing portfolios that are “livable,” while providing investment solutions that match an investor’s goals, risk tolerance, and other factors. This approach may, over the very long run, trail a true passive asset allocation that holds all investable markets in proportion to their market values. But as a practical compromise for real‑world investing, it’s a reasonable—if not compelling—concession to potentially deliver more stable outcomes for investors who must balance growth with the practical realities of time, behavior, and risk.

• Lofty stock market valuations leave little room for error if AI earnings don’t keep delivering

• The S&P 500’s AI tailwind is strong, but the headwinds may be getting stronger

• AI is still powering the S&P 500, but China’s fast‑moving challengers are tightening the competitive screws

The US stock market has been on a wild ride this year, but the Middle East conflict has yet to dent bullish expectations. A key reason: enthusiasm for artificial intelligence (AI) as a business model. Wall Street projects this tech story will lift earnings at a robust rate well into the future.

The combination of AI‑related infrastructure spending and opportunities for selling AI services to businesses and consumers has fueled expectations that this leading edge of technology development will continue to drive corporate bottom lines to new heights in the near term.

FactSet estimates that that year-over-year earnings growth for S&P 500 companies will rise more than 23% in Q2, which would mark a second-straight quarter of growth at a 20%-plus pace. The forecast also reflects a strong improvement over the roughly 15% earnings growth that was expected when the year began, according to LSEG IBES data.

Despite Wall Street’s cheery outlook, the bull run isn’t without risk. One is the burgeoning threat of Chinese AI firms, which are charging far less than their American competitors. Models maintained by leading US firms, such as Anthropic and OpenAI, reportedly have an edge over systems offered by companies in China, but the gap is expected to narrow. Meantime, demand for China‑based systems is starting to gain traction. That persuades some analysts to argue that it’s just a matter of time before competitive pressures accelerate and potentially create stronger headwinds for AI‑driven earnings growth in the US.

Some analysts are beginning to question whether cash‑flow and earnings forecasts based on AI are too optimistic, given the rise of China‑based competition. Although no one can confidently predict how this business war will evolve, it’s clear that the crucial engine of optimism for the S&P 500 is increasingly bound up with assumptions that AI will do the heavy lifting to keep the earnings train rolling.

Buoyant earnings forecasts that hit the mark may become increasingly necessary at a time of elevated market valuations, which reflect assumptions that a best‑case scenario will prevail. A widely followed measure of price multiples for stocks is close to a record high. The Cyclically Adjusted PE Ratio (CAPE Ratio) is estimated at nearly 42 for July, near the 150‑year peak set during the dot‑com bubble in 1999–2000.

The pushback is that AI is generating earnings, whereas the tech bubble of a quarter century ago was largely driven by expectations—many of which failed to materialize in a timely manner. Fair point. But if the market is fully valued, if not excessively so (as some pundits argue), which implies relatively low expected returns, there’s little wiggle room for disappointment.

On that note, our update of expected return for the S&P 500 for the ten years ahead remains modest. In particular, the TMC Research average estimate for several models is a 5.6% annualized return for stocks – unchanged from our previous update in February, and still far below the market’s current trailing 13%-plus annualized rise over the past decade. As the chart below reminds, performance on a rolling ten-year basis has rarely been stronger.

As always, the standard caveat applies when attempting to divine the future. Accordingly, take this and all forecasts with a grain of salt. However, the hefty gap between expected and actual performance suggests things might soon snap back to reality in some degree. It all comes down to the classic question: Is it really different this time? If so, why?

The future isn’t bound by the past, and perhaps AI is a genuine game-changer. But with the market outperforming so dramatically, the burden of proof is increasingly on the bulls to explain and rationalize why high returns and stellar earnings reports will persist.

Here’s a quick review of each of the five models used to generate the forecasts above:

CAPE Ratio Model: this stock market valuation indicator, maintained by Professor Robert Shiller, is calculated using real earnings per share for the S&P 500 based on a rolling 10-year window. TMC Research uses the CAPE ratio to generate an implied return for the stock market.

Earnings Yield Model: the stock market’s implied ex ante performance is derived from the S&P 500’s earning yield, defined as the inverse of the price-to-earnings ratio.

ARIMA Model: In contrast with the two models above, which use valuation to infer future return, this estimate uses statistical analysis to generate a forecast. An autoregressive integrated moving average (ARIMA) model is a type of regression analysis that’s run on rolling window of the market’s return history to estimate future results.

Bayesian Model: This statistical model uses lags as a basis for updating so-called “prior beliefs” on a rolling basis to estimate the effects of previous effects on the S&P 500 to forecast return.

Average Historical Return Model: This naïve estimate is a simple average of all the rolling 10-year returns since 1960.

• Small caps are outperforming in 2026, fueled by stronger earnings expectations and bargain valuations.

• AI‑linked holdings and a resilient U.S. economy are adding momentum to the rally.

• The Fed tailwind could vanish quickly if the Iran crisis reignites inflation and forces renewed tightening.

Small-cap stocks are outperforming large caps and the broad market this year. Will it last?

It’s a reasonable question, given the multiple false starts in recent years when small caps took the lead only to trail soon after and yield to large caps. Analysts say this time could be different, citing several favorable tailwinds.

One possible driver is implied via performance history, which suggests small caps may be overdue for a run of outperformance after trailing larger firms for much of the past five years.

Investors in lesser-capitalization stocks are hoping for a rotation in leadership comparable to the roughly six-year runs of small-cap dominance in 2000–2006 and 2008–2013, based on the ratio for two ETFs: SPDR S&P 500 (SPY), which is heavily weighted in large caps, vs. iShares Core S&P Small-Cap ETF (IJR). As shown in the chart below, when this ratio is rising, large caps are outperforming; when the ratio falls, small caps are winning.

Keep in mind that outperformance sometimes means losing less. But so far in 2026, the small-cap edge is strong in both relative and absolute terms. The iShares Core S&P Small-Cap ETF (IJR) is up nearly 23% this year through July 6, according to Morningstar.com. That’s more than double the advance for the SPDR S&P 500 ETF (SPY).

Analysts cite several factors for the tailwind in small caps that could keep the party going, starting with a bullish outlook for earnings. Estimates for 2027 for the S&P 600, a small-cap index, have improved sharply relative to this year and 2025, according to Yardeni.com, a research shop. The forecasts also compare favorably vs. the outlook for large cap earnings (S&P 500).

Another driver, which may be underappreciated: small-cap indexes hold semiconductors and other stocks linked to artificial intelligence and the recent surge in related infrastructure spending. As one example, Morningstar reports that the tech sector recently represented around 15% of holdings for the iShares Core S&P Small-Cap ETF (IJR), which includes MaxLinear (MXL), a maker of radio-frequency and mixed-signal chips that has jumped as cloud platforms and semiconductor firms accelerate buildouts for AI-driven connectivity.

Comparatively attractive valuations for small caps are also supportive. In contrast with the big-cap AI- and tech-driven large-cap space, which have posted lofty price-to-earnings ratios, small-cap valuations started the year at a steep bargain by comparison -- approaching the lowest levels relative to large-caps in decades, according to one estimate.

A resilient US economy is also a factor. Strategists at Goldman Sachs advise that the business cycle “is usually the most important macro driver of small-cap US equities,” according to a research note published last week.

The path ahead for inflation could be a risk factor due to conflict with Iran, which has increased pricing pressure through a surge in energy costs. Although stocks generally can come under pressure if inflation heats up and the Federal Reserve responds by raising interest rates, small caps tend fare worse. One reason: Small‑cap firms are generally less profitable and more credit‑dependent, making them especially vulnerable to a surge in borrowing costs because they pay higher rates, face shorter‑term loans, and are exposed to greater interest‑rate volatility, strategists at Charles Schwab observe.

Relative calm in the Middle East, however, suggests inflation may have peaked. The Cleveland Fed’s latest nowcast show the year-over-year change the Consumer Price Index is expected to ease for the first time since the war began. The question is whether the return of military strikes this week threatens to renew inflation’s pulse.

The futures market is pricing in moderately high odds that the Federal Reserve will keep its target interest rate unchanged at the next policy meeting on July 29. A rate hike in September, however, is considered likely.

The recent tailwind from a steady Fed could prove fleeting if the Iran crisis escalates and energy prices surge again, rekindling inflation pressures and potentially forcing policymakers back into a tightening mode. In that scenario, small caps could once again take a back seat to large caps. For now, though, the small‑cap edge remains intact as 2026 enters its second half.

• Trimmed‑mean inflation is substantially cooler than standard price measures

• Markets are expecting rate hikes despite calmer trimmed‑mean readings

• The Fed faces mixed signals at a pivotal policy moment

The latest inflation numbers aren’t especially encouraging for Fed Chair Kevin Warsh, who emphasized at his first policy meeting two weeks ago that the central bank “will deliver price stability.” But the new Fed chief is a fan of so‑called trimmed‑mean inflation, which currently reflects a substantially lower, steadier pricing trend. The question is whether this alternative model for tracking inflation will persuade the Fed to delay—if not forgo—rate hikes.

Warsh appears committed to using alternative price measures and seems intent on giving them a larger role in Fed policy decisions. During his Senate confirmation hearing in April, he argued that “the data that’s being used to judge inflation is quite imperfect.” As a solution, he urged the Fed to focus on “trimmed averages” for a clearer, more reliable measure of the “underlying, generalized change in prices in the economy.”

That’s a provocative idea at a time when a leading proxy for the trimmed‑mean inflation rate is running at a pace substantially below the Fed’s standard inflation metrics. Using the latest numbers for May, the one‑year change in the Dallas Fed’s trimmed‑mean core (excluding food and energy) PCE price index is a comparatively tame 2.4%, only modestly above the Fed’s 2% inflation target. By this standard, the Fed can afford to be patient about a future policy pivot.

By contrast, the standard core PCE inflation trend that the Fed has long focused on is considerably hotter, posting a 3.4% increase over the year‑ago level—the highest since late 2023 (green line in chart). Headline PCE, which includes food and energy, is even higher, topping a 4% annual pace through May for the first time in three years (black line).

The trimmed‑mean methodology drops the largest and smallest price changes and calculates inflation from the weighted average of the remaining, more representative items. Supporters say this approach can be superior because it filters out the most volatile monthly price swings, providing a steadier, more accurate real‑time signal of underlying inflation trends and future inflation than traditional core measures, which simply exclude fixed categories like food and energy.

But what sounds encouraging in theory doesn’t always translate into an advantage in practice. As the chart above shows, trimmed‑mean PCE inflation was slow to react to the 2021–2022 inflation surge compared with the standard PCE measures.

When the Fed began raising rates in March 2022, critics charged that policymakers had waited too long, allowing pricing pressure to run higher and last longer than if a hawkish pivot had come earlier. The slow change in trimmed‑mean inflation suggests that relying too heavily on this measure would have left the Fed even further behind in responding to the pandemic‑related inflation spike.

Whatever the flaws or advantages of trimmed‑mean inflation, it isn’t expected to play an outsized role in Fed decisions any time soon. That, at least, is the implied forecast from the Fed funds futures market, which is pricing in rising odds of rate hikes in the near term. For example, the roughly 30% estimated probability of tighter policy at the next FOMC meeting on July 29 climbs to 62% for September. The priced outlook for another hike later in the year has also been edging higher.

Even so, the path ahead for the Fed remains fluid, buffeted by shifting assessments of geopolitical risk in the Middle East and its impact on energy exports—an input that remains central to inflation expectations. The sharp drop in crude oil prices in recent weeks is, for now, holding, a decline that will soon translate into lower headline inflation pressure. The concern is that standard measures of core inflation, regardless of near‑term energy trends, may already be set on a path to rise further and widen the gap over the Fed’s 2% target.

Meanwhile, it’s unclear how much influence the trimmed‑mean data will exert on the Federal Open Market Committee and its upcoming decisions on interest rates.

One thing is certain: Warsh’s preferred inflation gauge may be trimmed—but the debate over its power to shape Fed policy is anything but.

• Fed stance has slipped into a dovish bias as our neutral rate estimate rises

• Rising inflation pushed the model’s neutral rate higher

• Fed funds futures are pricing in higher odds of rate hikes

Fed Chair Kevin Warsh struck a hawkish tone at his debut press conference last week, but the central bank’s policy stance has turned dovish in recent days, according to TMC Research’s Fed model.

For the first time in three years, the Effective Fed Funds Rate has fallen below our estimate of the neutral level of the Fed’s target rate—a gap that suggests monetary policy has shifted to a dovish bias (roughly 40 basis points below neutral as of June 24).

It’s important to understand the mechanics behind the shift. The Effective Fed Funds Rate has been unchanged since the Fed cut rates in December 2025. What has changed is one of the inputs to our model: inflation via the Consumer Price Index. The recent rise in CPI has pushed our estimate of the neutral rate higher.

The key takeaway: the Fed’s policy bias appears to have moved from moderately tight to moderately loose—not because of any new action by the central bank, but because of its lack of action in the wake of hotter prices.

The debate is whether the recent upturn in inflation will prove temporary, which would ease pressure on the Fed to tighten policy through one or more rate hikes. The risk is that stronger pricing pressure persists. If so, the longer the Fed waits to respond, the greater the possibility that inflation becomes more entrenched—forcing the Fed to raise rates higher and keep them elevated longer than would have been necessary with earlier action.

Warsh refrained from offering forward guidance at last week’s meeting, but almost half of the Fed’s members of the Federal Open Market Committee project at least one rate hike by year‑end, and several believe multiple increases may be needed.

Although Warsh has been critical of the Fed’s forward‑guidance efforts—such as publishing rate forecasts by FOMC members—he emphasized that “the Committee will deliver price stability.” He also noted that “inflation has been running well ahead of the Fed’s long‑stated inflation goal of 2%—that’s been going on for more than five years. Persistently high prices are a burden for the American people.”

The uncertainty is whether the Fed will soon raise rates or continue a wait‑and‑see approach that assumes the recent rise in inflation is temporary. The sharp drop in oil prices over the past several weeks—driven by what appears to be an end to the war with Iran—supports the view that headline inflation may have peaked and could soon ease.

Fed funds futures are pricing in roughly a 72% probability that the Fed will leave its target rate unchanged at next month’s FOMC meeting. For September, the probability rises to 87% for either no change or a cut.

The bond market also appears to be giving the Fed more room to be patient, if not implicitly assuming the inflation surge will prove transitory. The 10‑year Treasury yield, for example, has pulled back from its mid‑May spike, trading around 4.40% versus nearly 4.70% a month ago, although the current yield is still up sharply relative to where it began, just below 4.0%, on the eve of the war’s start.

The Fed’s next move is uncertain, but the window for inaction is getting narrower by the day. At some point soon, the inflation data will force a decision, one way or the other.

• Several asset classes beat the S&P 500 during the 2026 drawdown

• Treasuries, commodities, and cash have routinely outperformed the S&P in recent drawdowns

• Cash remained the only asset to post absolute outperformance in every major drawdown since 2007

The recent rise in the correlation between stocks and bonds has sparked debate about assumptions for risk models and the role of asset allocation. The market volatility triggered by the Iran conflict has only sharpened the discussion about what to expect from cross‑asset relationships in the design and management of investment portfolios.

One way to monitor and evaluate asset allocation’s value as a risk-management tool is tracking how markets behave during the steepest drawdowns for U.S. stocks. Last October, TMC Research analyzed the five deepest peak‑to‑trough declines in the S&P 500 Index since 2007 relative to ten markets that, at various times, provide some degree of hedging against sharp losses in U.S. equities. In today’s update, the results of this year’s S&P 500 drawdown are added to the mix.

As shown in the table below, the benefits of a diversified portfolio across asset classes proved valuable once more in the recent stock-market decline. This year’s S&P 500 drawdown was relatively moderate by historical standards—the 11th deepest since 2007, briefly touching a 9.1% loss from the previous peak. Seven of the ten markets listed outperformed U.S. stocks, either in relative or absolute terms, based on a set of proxy ETFs.

The dates shown in the table (reading left to right) indicate the S&P’s peaks and troughs for each drawdown event. This year’s decline (bottom row) cut the S&P by 9.1% before the market recovered.

The assets that fared worse than the S&P 500 during this year’s drawdown: gold (GLD), large‑cap growth stocks (IVW), and emerging‑markets equities (VWO). The best performer during this year’s correction: commodities (DBC), which surged more than 17% during the S&P 500’s slide.

Note, too, that only three asset classes have outperformed the S&P in all six drawdown events listed in the table: Treasuries (IEF), commodities (DBC), and cash (SHV). Although outright gains were recorded in several cases, only cash (SHV) consistently outperformed in absolute terms across all six episodes.

The key lesson from the results above is unchanged from our previous update: diversifying across asset classes remains a useful risk‑management tool. Although the relationships between asset classes aren’t fixed and continue to evolve, the general strategy of holding a global portfolio as a hedge against uncertainty still looks compelling.

History doesn’t offer any guarantees on how assets will perform in the next crisis, but using this year’s stock‑market correction as a guide suggests that maintaining broad, multi‑asset exposure is a powerful tool for navigating an increasingly unstable investment landscape.

• Narratives can move prices, too, influencing investors beyond “normal” market volatility

• Perceived risk can overtake actual risk when narratives dominate

• Hidden narratives can quietly steer investment decisions

Are you reacting to market volatility – or stories about it? Both can potentially steer investors off course from their long‑term financial goals without careful planning, but one is more subtle, and therefore can pose a bigger risk.

So‑called narrative risk comes in many forms, including content from social and mainstream media. That creates a threat that can be especially stealthy for otherwise sound judgment in money management. Consider market volatility: when it strikes, it’s obvious, reflecting a measurable move in asset prices. Sharp drops in the stock market are immediately evident, not to mention expected for anyone who studies financial history in the context of long‑term planning. A carefully designed diversified portfolio, rebalancing rules, and a long time horizon all assume volatility will show up.

By comparison, narratives about market volatility can be more understated and, for some investors, fly under the radar. That’s a problem: if you are not aware of narrative risk, you may not be prepared for it.

Behavioral Traps and Narrative Risk

Recent research highlights the potential for trouble. The power of financial narratives arises from the emotions they generate.

“We find investor emotions are associated with up to 52% of market returns and 67% of market uncertainty during these market crises, and provide general evidence that investor emotional dynamics may be time and context invariant,” advise the authors of “Narrative Emotions and Market Crises,” a study published in the Journal of Behavioral Finance last year.

Another recent study – “Competing Narratives in Financial Markets” – outlines how viral narratives can drive bubbles, crashes, and volatility through opinion dynamics, fueling the possibility that competing stories can create instability even without new economic information. The key takeaway: Viral stories and social media hype can be a bigger factor in changing asset prices compared with a company’s actual financial health. By simulating a digital stock market, the researchers demonstrate that when investors split into opposing groups—like “bulls” who believe a stock will skyrocket vs. “bears” who think it will crash—their social circles turn into echo chambers that fuel massive, unpredictable price swings.

When Narratives Become Market Movers

The lesson for investors is to be alert to herding behavior, a.k.a. FOMO or fear of missing out. When the crowd buys into a stock purely because a certain narrative goes viral, it may create unstable price bubbles that can violently burst the moment the crowd changes its mind.

Some researchers find that market crises are fundamentally psychological events. Because these emotional narrative cycles repeat almost identically across history, sophisticated investors should monitor mainstream financial media narratives not just for “facts,” but as a barometer for collective anxiety or denial. Recognizing when a market is heavily decoupled from fundamentals and driven by narrative‑induced emotions can help investors avoid panic‑selling during crashes or over‑buying during bubbles.

Narrative risk appears to be a growing threat as social media deepens its reach and influence among investors. And unlike traditional volatility, which is visible on a chart, narrative volatility is invisible until it has already shaped behavior. That’s what makes it so hazardous: it doesn’t attack the portfolio first — it attacks the decision maker.

When stories about markets become louder than the markets themselves, investors may start reacting to perceived risk rather than actual risk. A headline that “stocks are plunging” can trigger anxiety even if the underlying move is routine and within a “normal” range. A viral post claiming a stock is “the next big thing” can override years of disciplined planning. In both cases, the narrative (rather than the fundamentals) can become a catalyst—perhaps unconsciously—for action.

For long‑term investors, the implication is clear: managing money requires managing the information ecosystem that surrounds it. That means:

Treating narratives as data. If the emotional tone of financial news is spiking, that’s a signal that collective psychology may be shifting.

Separating noise from signal. Volatility is normal; narrative amplification is optional. Investors who can distinguish between the two are less likely to overreact.

Re‑anchoring to fundamentals. When stories become extreme, returning to earnings, cash flows, valuations, and long‑term goals provides a stabilizing counterweight.

Building behavioral guardrails. Pre‑committed rebalancing rules, automatic contributions, and written investment policies generally help neutralize narrative‑driven impulses.

The bottom line: market volatility tests portfolios, but narrative volatility tests investors. The former is built into every financial plan; the latter can quietly unravel one. In an age when stories spread faster than facts, the real competitive advantage is not predicting the next narrative — it’s refusing to be ruled by it.

• Recession odds stay low as growth outperforms crisis expectations

• TMC’s recession indicator signals resilience, not contraction, despite inflation pressures

• Stronger hiring and firming GDP keep the Fed in wait‑and‑see mode

At the start of the Iran conflict, many analysts expected US economic growth would stumble and recession risk would spike. It was a reasonable view at the time, although TMC Research noted a few days after the war started that our “Recession Probability Indicator (RPI) continues to reflect a low probability that an NBER-defined downturn has started or is imminent.” An update of the numbers suggests more of the same.

More than three months into the Middle East crisis, the American economy still looks resilient. Inflation is an ongoing threat, thanks to the supply-side energy shock that’s lifted prices. But growth has held up better than expected, and the odds appear low that the economy is on the precipice of a material slowdown, much less an outright contraction.

The TMC Recession Probability Indicator (RPI) is currently estimating that it’s highly unlikely the economy is shrinking or will soon slip over the edge. That doesn’t mean macro risks are absent – quite the opposite. Rather, RPI reports that the quantitative signals that usually flag elevated recession risk are subdued at the moment. (RPI aggregates and processes data from three business‑cycle indicators published by regional Fed banks — see here for details.)

Last week’s release of payrolls data for May aligns with RPI’s growth bias. Hiring increased by 172,000 positions last month, beating expectations by a wide margin and marking the third straight month of relatively strong employment gains. Meanwhile, the jobless rate was unchanged at a low 4.3%.

While hiring has remained relatively resilient, the majority of recent job creation has been concentrated in the healthcare and hospitality sectors, and many other industries continue to struggle. At the same time, consumer sentiment remained near record lows in May, signaling a considerable degree of unease among households.

From a top-down perspective, however, the near-term outlook remains upbeat. For example, the Atlanta Fed’s GDP nowcast for the upcoming second‑quarter economic report is on track to accelerate to a 3.3% annualized pace, according to the bank’s model (June 9). If correct, the rate of output’s increase will more than double from Q1’s 1.6% advance.

None of this should dismiss the concern that the ongoing effects from the crisis pose a threat to the economy, primarily in the form of higher inflation. The key variable is how long the conflict lasts, which will likely determine when energy exports through the Strait of Hormuz rebound to something approximating normal — a shift that would, in turn, likely cool the recent inflation surge.

Forecasting such a turn of events is extremely challenging, although that won’t stop journalists from posing the question to Kevin Warsh, the new Federal Reserve chair, who will field these and related topics for the first time at the central bank’s press conference next week.

The economy’s resilience to date will give the Fed cover for leaving interest rates steady at next week’s June 16–17 policy meeting. But the resilience also suggests a strengthening case for raising rates. If economic activity is firming at a time when inflation is heating up, tightening monetary policy is a reasonable response at some point.

Fed funds futures currently estimate low odds for a rate hike next week and at the subsequent meeting in late July. But sentiment is starting to lean into a hawkish policy pivot later in the year – an outlook that will continue to resonate if recession‑risk odds stay low.

• New research provides strong evidence that investor beliefs—not fundamentals—drive long‑term market dynamics

• Sophisticated investors tend to be contrarian, while retail investors often extrapolate past returns.

• Valuation ratios like CAPE reflect sophisticated—not retail—expectations about future returns

How do financial markets price stocks? The answer matters because it provides information for designing and managing investment strategies.

A dominant line of analysis in asset pricing argues that long-term stock market fluctuations are driven by fundamentals like time-varying risk premia. However, a new research paper challenges this understanding by modeling the market as an interaction between naive investors (whose beliefs are decoupled from fundamentals) and sophisticated investors, using a new 70-year dataset to support the findings.

A key takeaway is that shifts in valuation ratios are almost entirely driven by expected changes in investor sentiment and price mean-reversion, not by changing expectations of dividend or earnings growth.

The paper also provides more context and support for engaging in tactical tilts at times. The standard academic and industry view—rooted in the Efficient Market Hypothesis (EMH)—holds that markets are broadly “efficient,” making buy‑and‑hold, market‑cap‑weighted indexing the logical baseline. Volatility, in this framework, simply reflects “rational” investors updating expectations. The EMH has been hard to beat over long horizons, but behavioral finance has steadily shown that real‑world investing is more complicated. Markets may be efficient enough to justify indexing, yet not so efficient that tactical adjustments are entirely pointless.

A new research paper strengthens this case for periodically adjusting portfolios beyond what a simple buy-and-hold strategy implies. In Beliefs and Stock Market Fluctuations: New Evidence from the Past Seven Decades, MIT Sloan economists David Thesmar and Emil Verner analyze seven decades of data and uncover three central findings about how different investors form expectations.

Sophisticated Investors Are Contrarian; Retail Investors Extrapolate

The idea of a unified “market consensus” is misleading. Beliefs are fragmented—and often move in opposite directions. Retail investors, as shown in surveys, are highly procyclical and extrapolative: when markets rise, they assume gains will continue and their expected returns peak near market tops. Value Line analysts, who are used in the paper as a proxy for “sophisticated” investors, behave very differently. Their expectations are countercyclical: when markets fall, they anticipate higher future returns.

Valuation Ratios Reflect Sophisticated, Not Retail, Expectations

Valuation metrics, such as the cyclically adjusted earnings-price ratio (CAPE) and earnings-price (E/P) ratio, have long been known to predict long‑term returns. Thesmar and Verner show whose beliefs they actually capture. A time‑series regression of the market’s earnings-price (E/P) ratio on Value Line’s expected returns produces an R² of 65%. Low valuations tend to align with high expected returns among sophisticated investors—exactly what rational models predict. Retail surveys generally show no such relationship. A Campbell‑Shiller decomposition reinforces the point, the study notes:

• Roughly 60% of variation in price-earnings ratios stems from shifts in sophisticated investors’ expected returns.

• 0% comes from expected changes in cash flows or dividend growth.

A graphic in the study captures the point, showing that the Value Line expected returns “account for a large share of movements in valuation.”

Disagreement Drives Volume and Volatility

If sophisticated investors are closer to rational, why do bubbles and crashes still occur? Limits to arbitrage. When retail optimism surges, naive investors buy aggressively, pushing prices above fundamentals. Sophisticated investors recognize the mispricing but cannot fully counteract it due to risk constraints. The resulting expectation gap fuels trading. When disagreement between Value Line and retail investors spikes, market volume and volatility jump as the two groups trade against each other.

The authors report that retail investors at times persist in pushing prices away from fundamentals, while sophisticated investors trade against them and can forecast future returns. The historical record, in other words, supports contrarian‑leaning strategies at times. In the jargon of financial researchers, “heterogeneous beliefs matter for market dynamics,” the paper notes.

Theory and Practice

This is old news for some investors. The likes of Warren Buffett and other value investors have been profitably exploiting this behavioral gap for decades. By some accounts the Oracle of Omaha’s impressive track record is an anomaly. Thesmar and Verner’s research, however, suggests there’s a recurring behavioral risk factor embedded in the stock market that can be used for tactical tilts, even within an indexing‑first philosophy.

Markets are smart, but they aren’t flawless. While low-cost indexing remains the smartest anchor for most portfolios, this research reminds us that human nature never changes. For the indexing-first investor, that means the occasional tactical tilt may not just be a gamble—recent research increasingly suggests it’s a data‑driven response to a persistent behavioral reality.

• Hotter inflation will feature at Warsh’s first policy meeting and press conference this month

• His June 17 debut will reveal how he handles rising price pressure

• The Treasury market hints at a rate hike in the near term

Federal Reserve Chair Kevin Warsh will preside over his first Federal Open Market Committee (FOMC) meeting later this month (June 16–17). Ahead of his public debut as the top central banker, monetary policy is essentially neutral for the first time in 2½ years, according to TMC Research’s estimate. Inflation, by contrast, is trending higher, which may set up an early challenge for the newly minted Fed chief.

Fed funds futures are still pricing in a near‑certainty that the Fed will leave its current 3.50%–3.75% target range unchanged this month, but the Treasury market is sending a different message for later in the year. The 2‑year Treasury yield — widely viewed as a proxy for policy expectations — is trading just above 4.0%, moderately above the high end of the Fed funds target range and implying that a rate hike may be near.

The concern is that the recent pickup in headline inflation will soon force the Fed’s hand and trigger one or more rate hikes to offset renewed pricing pressure. The case for rate hikes has been debatable, even after the inflation jump triggered by the conflict in the Middle East. TMC Research’s Fed Funds Model has estimated policy as moderately tight, offering a degree of inflation‑fighting medicine. But that mildly hawkish bias has continued to fade in recent months and is now essentially neutral, leaving the Fed vulnerable if inflation holds at current levels or rises further.

Several measures of inflation have jumped in recent months, driven by the Middle East supply shock that has lifted energy prices. The year‑over‑year change in the Consumer Price Index (CPI) rose to 3.8% through April — a three‑year high and substantially above the 2.4% pre‑war pace in February. Core CPI, which strips out food and energy and is a more reliable measure of underlying inflation, is also edging up but remains considerably softer at 2.7%. In both cases, inflation is running hotter than the Fed’s 2% target.

Warsh’s preferred measure of inflation, by contrast, suggests that inflation is lower and stable, giving the Fed chair more leeway to argue that rate hikes are premature. In his Senate confirmation hearing in April, he said he favors “trimmed” inflation measures, explaining that they offer better signals of underlying trends.

The Dallas Fed’s Trimmed Mean Personal Consumption Expenditures (PCE) Index, for example, rose 2.4% for the year through April, unchanged from March and only slightly higher than February’s pace.

Critics push back by noting that the trimmed‑mean PCE Index was slow to react to the 2021–2022 inflation spike, and so relying on this alternative measure could set the Fed up for another delayed reaction that gives pricing pressure room to run.

The Cleveland Fed’s inflation nowcast, however, suggests the current inflation run may be peaking. Headline CPI is expected to ease modestly in June to a 3.9% year‑over‑year rate, down from a projected 4.2% increase in the upcoming May report. Core CPI, meanwhile, is on track to hold steady at 2.8%.

The question is how the 12 members of the FOMC interpret the data. The focus on June 17 will be on the first among equals for policy votes — Warsh — who gives his first press conference as Fed chair that afternoon.

His preference for trimmed‑mean inflation will be under scrutiny, and will likely be subject to questions from the press. How he defends that preference under the glare of a live press conference will offer the first real clue about the kind of Fed chair he intends to be.

• Volatility exposes investor psychology

• Behavioral biases spike precisely when discipline matters most

• Rules tend to beat emotions most of the time

Market volatility doesn’t just rattle markets—it rattles investors, which in turn exposes behavioral risk. When markets lurch and headlines turn chaotic, that’s when dormant biases like loss aversion, herding, and overconfidence can surge to the surface and quietly steer investors toward costly decisions.

In a previous essay, we outlined several steps for reviewing your portfolio strategy when market volatility spikes. That discussion assumed a rational, cool‑headed investor—an assumption that may be too generous at times, especially during market downturns. As a complement, let’s consider the behavioral dimension during periods of market turbulence, focusing on the key risks to be aware of.

There are many behavioral-related hazards, but five stand out as especially dangerous during market corrections and bear markets. Maintaining discipline during elevated financial stress—and resisting emotionally-driven decisions that can derail long‑term goals—is never easy, but it’s always essential.

The research is clear: the costliest mistakes happen when emotions masquerade as insight. In that sense, volatility doesn’t cause those errors—it reveals them.

It’s also fair to say that behavioral risk in investing is a persistent challenge. Markets evolve, but human nature is remarkably consistent, as a recent study suggests (“Behavioral Finance in the Sphere of Investment”). The analysis reviewed 30 studies published between 2020 and 2025 that examined behavioral finance and its influence on investment choices. “The results indicate that investor psychology continues to play a dominant role in financial decision making, with biases shaping investment behaviors across different economic and technological contexts,” the authors report.

The first step in playing defense is recognizing the behavioral traps that can surface in turbulent periods. Here are five to keep on your radar.

Loss Aversion (The Pain of Drastic Drops)

Psychologically, the pain of losing money is roughly twice as intense as the joy of making the same amount. When volatility strikes, this asymmetric pain can trigger a survival instinct, tempting investors to “stop the bleeding.”

The key risk: Selling assets at or near the bottom of a drawdown in pursuit of emotional relief, turning temporary paper losses into permanent capital destruction.

To be clear, selling may be reasonable, even in a downturn. But reducing exposure to risk assets because of a predetermined set of rules may be quite different from selling because you’re triggered by news headlines.

Recency Bias (Extrapolating the Present)

Human brains naturally overweight recent events when forecasting the future. In calm markets, we assume smooth sailing indefinitely; during a sharp correction, it’s all too easy to let the darker angels of your brain assume that the downward trend will continue straight to zero.

The key risk: Forgetting the long‑term historical data on market cycles and regime shifts. This bias makes it especially difficult to maintain a rebalancing schedule, which inherently requires buying assets that have recently performed poorly, and paring back on the strongest performers.

Herding Behavior (Following the Crowd)

When uncertainty peaks, looking to the crowd for validation is a natural human response. If the financial press and broader market are panicking, individual investors often find it difficult to stand firm or look for value.

The key risk: Joining the stampede out of an asset class just as expected risk premiums are rising and prospective long‑term returns are improving.

Action Bias (The Urge to “Do Something”)

During an economic or market shock, sitting still can feel like negligence for some investors. This drive to take control can lead to over‑trading during the worst possible macro environments.

The key risk: Tweaking asset‑allocation models mid‑crisis, over‑hedging after the volatility spike has already occurred, or constantly shuffling positions. This behavior racks up transaction costs, creates tax drag, and typically results in whipsawing the portfolio. Once again, carefully developing an investment strategy before a shock, and sticking to the plan, can be a guardrail.

Information‑Avoidance Bias (Ignoring Negative or Discomforting Data)

This is the opposite of action bias: Some investors manage stress by disengaging entirely—a pattern often referred to as the “ostrich effect.” They stop checking performance metrics, ignore risk reports, and delay necessary portfolio maintenance.

The key risk: Missing critical rule‑based rebalancing windows or overlooking a fundamental shift in macro indicators that genuinely requires a programmatic adjustment to a tactical model.

• A spike in volatility is a reminder to revisit your investment plan—does it still match your goals?

• Rely on process — asset allocation, rebalancing, and tax-loss harvesting

• Look for opportunities to swap into lower-cost ETFs when harvesting losses

Bond yields are rising again, and some pundits say that the spillover could start to pressure stocks.

In moments like these, it’s easy to feel the temptation to retreat into cash, overhaul your portfolio, or chase whatever seems safe. But those impulses carry their own risks, and can potentially knock long‑term plans off track.

A better way to navigate periods of market stress is to treat volatility as a prompt to reassess and reinforce the parts of your strategy that actually drive long‑term results—while reducing the short‑term behavioral risks that can quietly undermine them. When markets turn rocky, these five forecast‑free tasks are worth revisiting to help keep your investment plan moving in the right direction.

Asset Allocation

Reassessing your asset‑allocation plan during periods of market stress is a practical way to make sure your portfolio still reflects your goals and your true tolerance for risk. Volatility has a way of exposing whether your mix of stocks, bonds, cash, and other assets is still aligned with your long‑term strategy—or whether market moves have quietly pushed you off target. Taking a fresh look at your asset allocation plan also gives you a clearer read on how comfortable you really are with your current level of risk when conditions get bumpy.

This isn’t about reacting to headlines or trying to time the next move. It’s about confirming that your allocation still fits your objectives, time horizon, and capacity to stay invested through uncertainty. The value proposition is straightforward: a well‑aligned asset‑allocation plan helps reduce emotional decision‑making and keeps your long‑term strategy intact when markets are most distracting.

Rebalancing

Rebalancing becomes especially valuable during periods of market stress, when asset prices move sharply and portfolios can drift away from their intended mix. Volatility can create meaningful gaps between your target weights and the actual holdings, leaving you either unintentionally overexposed to risk or too conservative at precisely the wrong time. Revisiting your rebalancing plan in these moments helps ensure your portfolio stays aligned with your long‑term strategy rather than the market’s latest swings.

The goal isn’t to react to every bump in the market, but to use volatility as an opportunity to realign your portfolio in a disciplined, tax‑aware way. Systematic rebalancing helps you trim what has become too large, add to areas that have lagged, and maintain the risk profile you intended. The agenda is clear: a consistent rebalancing process keeps your strategy on course and reduces the odds that short‑term turbulence will push you into decisions that undermine long‑term results.

Tax-loss Harvesting

Here’s another area worth revisiting when markets turn volatile. Sharp declines can create potential opportunities to realize losses in a controlled, intentional way—allowing you to offset current or future capital gains, reduce your tax bill, and reinvest the proceeds in similar exposures without disrupting your overall strategy. Periods of stress often widen the gap between winners and losers, making it easier to identify positions that can be harvested without compromising long‑term goals.

The value of this approach is straightforward: thoughtful tax‑loss harvesting turns market turbulence into a tangible benefit, improving after‑tax returns while keeping your portfolio aligned with its intended risk profile.

Use Tax Losses to Move Into Lower‑Expense ETFs

Periods of market stress often create opportunities to harvest tax losses, and those same moments may present opportunities for upgrading the underlying building blocks of your portfolio. When you sell a fund to realize a loss, you may be able to reinvest the proceeds in a similar—but not “substantially identical”—ETF with a lower expense ratio. This keeps your market exposure intact while reducing the ongoing cost of holding the position. (It is best to consult current IRS guidance and a tax adviser regarding wash sale rules and other tax considerations associated with tax-loss harvesting strategies.)

The benefit of this approach may include lowering expenses, which is one of the few levers investors fully control—even small reductions compound meaningfully over time. Using tax‑loss harvesting as a chance to swap into lower‑cost ETFs can turn a short‑term setback into a long‑term advantage, and may help improve tax efficiency and reduce portfolio costs while maintaining similar market exposure consistent with an investor’s overall investment strategy and risk tolerance.

Stay disciplined with contributions and withdrawals

Periods of market stress are an ideal time to revisit how consistently you’re adding to (or drawing from) your portfolio. For savers, maintaining regular contributions—especially through automated deposits—turns volatility into a potential advantage by buying more shares when prices are lower. For retirees or anyone taking withdrawals, stress periods are a cue to review your spending rate and ensure you’re not pulling too much from a declining market.

Steady contribution and withdrawal habits help smooth the impact of volatility, reduce the temptation to time the market, and keep your long‑term plan intact when conditions are most unsettled.

None of these steps are meant to replace personalized financial advice tailored to your specific goals, time horizon, or risk tolerance. Market volatility can be a useful reminder to revisit your broader financial plan. For many investors, working with a qualified financial adviser may be the best way to determine whether these strategies make sense within the context of their individual circumstances.

• Risk tolerance shifts with markets and emotions

• Static portfolios miss these swings

• Rules and periodic reviews keep investment decisions aligned with long‑term goals

Recent research is overturning the entrenched assumption that risk tolerance is relatively stable. New evidence shows it moves far more than most investors realize, which has several implications.

For starters, asset allocation should be dynamic to some degree rather than static. Regular re‑evaluation of risk profiles is also prudent.

Understanding your true risk tolerance is essential because it determines whether you can stay invested through the market’s inevitable ups and downs. When risk tolerance is misjudged, emotions may play an oversized role, which can lead to panic selling, performance chasing, and decisions that undermine long‑term results.

Getting this right is crucial because it creates the foundation for a portfolio you can stick with, no matter what the market throws your way.

The Fluidity of Risk

A growing body of research highlights that risk tolerance fluctuates and changes with market conditions, stress levels, recent performance, and even how portfolio and risk questions are presented. The key takeaway: Investors don’t have a single, fixed appetite for risk. They cycle through different levels of comfort and discomfort depending on what’s happening around them.

If risk tolerance moves with the market, then the moments when investors feel most confident often coincide with periods when risk is highest—and vice versa. This creates a behavioral trap: taking on too much risk after strong returns and pulling back too sharply after losses.

The research suggests that managing risk isn’t just about asset allocation; it’s also about understanding how emotions, context, and market cycles shape decision‑making. For investors, the challenge is learning to recognize these shifts and building a process that keeps short‑term feelings from derailing long‑term goals.

Data‑Driven Shifts

A recent study highlights how investor comfort with risk can fluctuate as market conditions shift. Fewer than one in six US adults (16%) in 2024 said they were willing to take financial risks, down from 20% in 2021, according to the FINRA Investor Education Foundation’s 2025 National Financial Capability Study. The study also notes that only 12% of adults were relatively tolerant of risk in 2009, soon after the financial crash. By 2015, after the market had rallied for several years, that share rose to 21%.

Another study found that risk preferences are dynamic and influenced by how choices are framed for 401(k) investment accounts. The authors of the 2024 research paper report that when you strip away participation barriers (such as confusing plan menus, default options, or the effort required to rebalance), more than 90% of investors would choose to hold stocks.

In contrast, “investors in the control groups who defaulted into a money market fund (or hired under an opt‑in regime) progressively increase their equity share away from their zero‑stock default,” the researchers found. “The fact that most investors move away from the default option when it is a safe asset but stay invested in the default when it is equity suggests that, absent participation frictions, these investors prefer holding risky assets.”

Practical Takeaways

In other words, the portfolios people want may be very different from the portfolios they actually end up with. If you prefer that your portfolio aligns with your real goals and risk preferences, you must actively overcome the frictions that push you toward inaction or misguided choices. Default options, old allocations, and “set‑and‑forget” choices can quietly steer you into a portfolio that doesn’t match your intentions.

Another line of analysis demonstrates that risk profiling should not rely on a one‑time questionnaire, but instead should be a continuous behavioral assessment. The paper advises: “Our findings indicate a better performance through financial returns for investors who answered behavioral finance questions and a higher retention for that group of investors with their financial advisor(s).” Risk, the author writes, “is never constant because it is shaped by both internal and external factors.”

For investors, the first step is recognizing that fluctuating risk tolerance is normal. Feeling more cautious after a market decline doesn’t mean you’ve suddenly become a conservative investor. These views may be emotional responses to recent experience and not reflect durable shifts in your financial identity.

Building guardrails can prevent temporary feelings from driving permanent decisions. This can take several forms, including:

• Defining rebalancing rules in advance

• Regularly reviewing investment strategy

• Assessing whether discomfort reflects a true change in goals or simply a reaction to market noise.

Financial advisors can play a critical role in this process. By helping clients distinguish between emotional shifts and structural changes, advisors can prevent the most damaging behavioral mistakes.

Markets, emotions, and life circumstances change. A resilient investment plan acknowledges this reality and builds in rules to keep short‑term feelings from overwhelming long‑term objectives.

• A reality check awaits the incoming Fed chair with tomorrow’s consumer inflation report for April

• Headline inflation stays hot while core and trimmed measures are relatively stable

• Inflation’s split signals complicate Warsh’s debut

By James Picerno | The Milwaukee Company

No one will be watching tomorrow’s update on US consumer inflation for April more closely than Kevin Warsh, who is expected to become chairman of the Federal Reserve this week following the Senate’s vote to confirm him.

The honeymoon may be short. Economists are forecasting that inflation will continue to accelerate at the headline level. The consensus estimate calls for a 3.8% year‑over‑year increase in the Consumer Price Index (CPI), according to Econoday.com — up from 3.3% in March. If correct, it will mark a second straight month of sharply rising pricing pressure, lifting the annual pace to a three‑year high.

Hotter inflation creates a challenge for Warsh, who has recently said that interest rates are too high — comments that have persuaded some observers that his hawkish reputation is softening. But the argument that rate cuts are prudent has become harder to make at a time when the energy shock from the war in the Middle East is driving up headline inflation.

In recent Senate testimony, Warsh recommended that the Fed refocus on the “trimmed averages” of inflation, which exclude outlier data and therefore offer a more robust profile of the trend. Notably, the Cleveland Fed’s Trimmed‑Mean CPI (T‑CPI) is running well below the Fed’s preferred inflation measure, the core Personal Consumption Expenditures index (core PCE), which excludes food and energy prices.

T‑CPI rose 2.6% for the year through March, matching the year‑over‑year gain in core CPI. By contrast, core PCE is running substantially hotter, at 3.2%, which is raising alarms in some circles that the Fed may soon need to hike rates.

The core PCE update will arrive at the end of May, but tomorrow’s CPI data may offer a preview. If economists are right, core CPI will edge up only slightly to a 2.7% increase versus the year‑ago level. The Cleveland Fed’s nowcast for April is a tick lower for the core reading.

Assuming those forecasts are accurate, the results may give Warsh some cover to argue that inflation is less threatening than it appears. Central bankers generally prefer core measures on the view that they offer a more reliable profile of inflation’s trend compared to headline inflation, which suffers from a higher degree of short-term noise.

The real challenge awaits in late May, when the core PCE numbers are released. The trend on this front is already running a full percentage point above the Fed’s 2% target.

It’s doubtful that Warsh will be able to persuade enough members of the Fed’s monetary policy committee to cut rates at the next meeting on June 17. Fed funds futures are pricing in a near‑certainty of no change.

Perhaps an even bigger issue to monitor is whether the new Fed chair’s views on rate cuts will evolve once he is confirmed for a four‑year term. A clue may emerge in tomorrow’s CPI report.

• Iran peace talks will dominate near‑term inflation risk through the energy channel

• Central banks are split as price pressures stay elevated and data stays hot

• Middle East stability — or renewed tension — remains the biggest swing factor ahead

A new peace proposal to end the war is reportedly under consideration between the US and Iran. Its success or failure will be a key driver of inflation risk, which has climbed since the conflict sent energy prices soaring. Even a durable end to the fighting — and a return to normal Gulf energy exports — would still leave elevated inflation pulsing through the global economy in the near term. The central question is whether hotter inflation proves temporary or persistent.

The answer will be a crucial factor for markets and the global economy in the weeks and months ahead. If price pressures stay higher for longer, the Federal Reserve and other central banks may feel compelled to tighten policy.

The Reserve Bank of Australia (RBA) decided earlier this week to start tightening policy. “As expected, developments in the Middle East are having an impact on inflation,” RBA announced. “Higher fuel prices are adding to inflation and there are indications that this is likely to have second-round effects on prices for goods and services more broadly.”

The Federal Reserve, by contrast, is widely expected to keep rates steady for now. Last week the Fed kept rates unchanged, and the Fed funds futures market expects the central bank will stand pat for the rest of the year.

Incoming data may be the final arbiter, starting with next week’s April CPI report. Headline inflation jumped to 3.3% in March — a two‑year high — and economists expect the 3%‑plus trend to continue, running well above the Fed’s 2% target.

The Cleveland Fed’s inflation nowcast also sees prices remaining sticky. The regional Fed bank estimates that headline CPI’s annual pace will heat up to 3.6% in April and 3.9% in May.

Markets tend to price geopolitical risk asymmetrically: escalation premiums build quickly, but they unwind only when investors believe a durable resolution is plausible. A credible peace framework would therefore have immediate implications for inflation expectations, especially through the energy channel.

The Federal Reserve is watching these dynamics closely. While policymakers do not react to geopolitical events directly, they do respond to the inflation expectations channel. A meaningful decline in energy‑driven inflation expectations would strengthen the case for future rate cuts, whereas continued uncertainty could keep the Fed cautious. The trajectory of the Iran conflict—and the credibility of any peace proposal—has become intertwined with the central bank’s policy outlook.

One sign of tentative optimism: the Treasury market’s implied inflation forecast has eased from its recent spike, with the 5‑year breakeven slipping to 2.58% (May 6) after peaking at 2.72% earlier this week.

Inflation’s path, however, will be shaped by far more than geopolitics. Wage growth, productivity trends, supply‑chain normalization, housing costs, consumer spending, and financial‑market conditions all influence how price pressures evolve. Layer on top the uncertainty surrounding global trade and fiscal policy, and the Fed faces a landscape where no single indicator can dominate the outlook.

Yet one factor stands above the rest in the near term: the trajectory of the Middle East conflict. Energy markets remain the fastest transmission channel for geopolitical shocks, and any shift toward peace — or renewed instability — would quickly ripple through oil prices, inflation expectations, and ultimately the Fed’s reaction function.

In an already crowded field of economic risks, the presence or absence of a credible peace framework is likely to exert the strongest influence on how inflation evolves in the months ahead.

• History leans toward resilience for equities after rate surges

• Forward 1‑ and 2‑year returns skew positive across many yield‑spike scenarios

• The first 3–6 months carry the most noise, making short‑run equity reactions highly path‑dependent

Inflation worries triggered by Middle East turmoil continue to hang over the global economy and financial markets. Economists are still debating whether hotter inflation driven by surging energy costs will persist or fade quickly once the conflict ends. The outcome may have implications for the US stock market.

The ongoing rise in Treasury yields is sharpening the focus on how equities might react to higher inflation. During Monday’s trading session, the 10‑year yield climbed to 4.44%, the highest level since the initial spike in late March. If the benchmark rate exceeds the war‑related peak of roughly 4.80% on Mar. 27, the move could signal a new phase for the bond market as investors demand a higher risk premium for fixed‑income securities.

To help manage expectations by studying history, TMC Research analyzed how US stocks (S&P 500 Index) have performed following run‑ups in interest rates, using the 10‑year yield as a proxy. The review covers market behavior since 1970, a period that includes several inflationary episodes. The common assumption is that equities routinely suffer when inflation heats up and interest rates rise. But a quantitative look at the historical record tells a more nuanced story, as shown in the chart summarizing the distribution of stock‑market performance over various time horizons following yield spikes.

There are many ways to test how the S&P 500 reacts to sharp increases in the 10‑year yield, but the chart above reflects one specific framework. The analysis uses monthly data to reduce short‑term noise and focuses on relatively large yield increases—defined as instances when the 10‑year yield jumps sharply relative to its lowest level over the prior six months. The S&P’s subsequent performance is grouped into four horizons: 3 months, 6 months, 1 year, and 2 years.

Within each horizon, the distribution of S&P outcomes is further divided into four buckets based on the size of the yield increase: 50, 100, 200, and 300 basis points.

For example, the blue bar in the upper‑left panel shows the range of S&P returns for the 3‑month window following a 50‑basis‑points or larger yield increase. The horizontal blue line marks the median return (2.5% in this case). The box represents the interquartile range (25th to 75th percentile), highlighting the most frequent outcomes. The vertical whiskers show the outliers—the most extreme performances.

For more context, each bar includes a sample‑size label (“n”). In the 3‑month, +50‑bps example, the sample size is 62. As the size of the yield increase rises, the sample size falls, reducing statistical reliability.

The “n” counts also reflect a 6‑month exclusion window to prevent a single, ongoing yield surge from generating multiple signals in quick succession.

In short, the analysis relies on a specific set of rules. Changing the rules will change the results, but the profiles above offer a useful first approximation for estimating how the stock market might respond if Treasury yields continue to rise.

The main takeaway: equities tend to be relatively resilient after yields rise. There’s no guarantee the future will repeat, but history suggests that yield spikes off cyclical lows have more often marked periods of equity strength rather than stress, especially over 6‑ to 24‑month horizons.

The caveat is that every event is unique, driven by different circumstances. That’s worth considering in the current climate, when the Iran conflict is injecting a geopolitical risk premium into energy markets and threatening to amplify inflation pressures in ways that may not align neatly with historical patterns.