Investor Behaviour through Market Declines – How Do We Stay On Track?

The general message being sent out from the investing world at this time is along the lines of ‘don’t panic’. This is all well and good, but just telling people not to panic may not be enough to stop emotions taking over, especially during this combination of global health and economic challenges.

If we can understand how our fears and emotions can affect our decisions, we stand a much better chance of riding out periods of volatility and uncertainty.

In this article, we look at some behaviours that we might be at risk to succumbing to during times like this and what we can try to do instead.

Fear of the unknown

Humans are naturally unable to tolerate much uncertainty. We may comfort ourselves with predictions or forecasts of what the future will hold, but the reality is, uncertainty is code for nobody has a clue what is going happen tomorrow. And as humans that scares us.

A 2016 study by University College London involved giving participants electric shocks. It found that people showed more signs of stress if they did not know whether they were going to be given an electric shock compared to being people that were told beforehand that they definitely will be receiving a shock.

This behaviour is reflected in stock markets where even the slightest hint of future uncertainty, good or bad, can lead to significant and unexpected short-term volatility.

Risk & Emotions

When times are good, we may confuse what feels good in the moment to what is actually sensible risk management for our circumstances. The recent bull market lasted a record 11 years, and some investors had never to date experienced any form of a downturn in their portfolio.

People may be investing heavily in equities as this feels good – equities always generate a positive return, right?

However, this may not be appropriate for their own circumstances or tolerance for loss. So, when times are not so good, a downturn can cause great panic and emotional pain around perceived losses in the portfolio.

Probability neglect

Unprecedented situations, as we are currently experiencing, put us at risk of making bad investment decisions due to expectation of probability. This is when our memories give too much weight to the probability of an unlikely event occurring.

Our irrational fear of an unlikely event occurring can have indirect negative consequences. For example, in one study (Source: Guardian), it is thought that following the 9/11 events, demand for air travel fell drastically out of fear that a similar event would occur. This meant there was a significant increase in car travel. The following year, there was a huge increase in the number of car accidents.

With investing, we may invest too heavily in one particular asset just because it has experienced a rise in the past. Some people sit on the sidelines altogether out of fear a great depression is always just around the corner.

Overconfidence

When markets do decline, there is indeed an opportunity to buy securities at lower prices. It is tempting to attempt pick stocks we think will rise in value in the future. Unfortunately, the majority of people rate their own ability in most areas as above average, which is statistically impossible.

With investing, we may believe our own predictions or forecasts are more insightful or skilful than the average person. However, this could cause us to bet too heavily on an individual stock or risky asset, which might backfire.

 

How can we avoid these?

The first step is to make sure any investment you do have is an appropriate risk level for what you are trying to achieve. Do you need to be heavily invested in equities? Would it be better for you to take less risk for more peace of mind if you knew you could still achieve everything you want to? Just because you have the willingness to take risk doesn’t mean you always should.

One element of Life-Centered Financial Planning is helping you figure out what is enough for you to live the life you want and what you need to do you get there.

Next, we should put our faith in the science around investing, not with the financial media. Following an evidence-based investment approach will ensure you are investing based on scientific principles rooted in research and historical data over decades, not temporary emotions or predictions. This involves being broadly diversified by geography and asset class and not betting on individual stocks.

History will tell us that yes, while the ‘when’ and depth of the bottom this decline is uncertain. We know that recovery is certain. By following the evidence that over the long term, the advance of markets is permanent, we will be rewarded.

We should pay as little attention possible to financial news. Humans are wired to deal with immediate threats and short term dips in markets are processed by our brain as a threat to our wellbeing, causing us to panic buy and panic sell.

This part is easier said than done, we may be unaware that we are subconsciously taking in news around markets, which may affect our behaviour, especially with drops as steep as we have seen in this past month. Sometimes it’s better to seek the help of a financial planner you can help keep your financial behaviours in check rather than try to go it alone.

As part of our ongoing relationship with clients, we ensure you stay on track with what’s important to you and stop unhelpful news or behaviours from getting in the way of your life goals. Contact us here today to find out how we can help.