“Be fearful when others are greedy and greedy when others are fearful.”
– Warren Buffett
Recognize the Biases & the Psychological Power of Loss
Staying calm when the stock market gets scary can be one of the most difficult aspects of investing. While stocks are historically the most lucrative asset class, the stock market’s unique combination of liquidity and volatility can lead investors to sabotage returns with irrational, fear-based decisions. Recognizing the emotional and cognitive biases that result from this fear can help investors avoid poor outcomes.
Sharp declines in the stock market can be particularly unsettling because the human psyche is predisposed to prioritize avoiding losses over capturing gains. Although traditional economics posits that a $1,000 loss should decrease satisfaction by the same amount that a $1,000 gain increases satisfaction, behavioral economists have found that losses can be twice as powerful psychologically as gains of the same magnitude. This makes properly balancing risk and reward in a stock portfolio even more difficult, yet all the more crucial during times of stock market turmoil.
Counteracting Loss Aversion
When faced with a volatile stock market, investors often react fearfully by selling stocks at low prices in order to avoid losses. This proves to be an expensive mistake as countless academic studies have shown attempts at market timing to be counterproductive. Broad stock market corrections are inevitable, but also temporary – properly diversified portfolios always recover when the market rebounds.
Rather than focusing on avoiding losses, investors can counteract their loss aversion by thinking of the gains they relinquish when moving out of stocks. Investors on the sidelines are certain to miss out on gains when the market inevitably bounces back.
Avoid Herd Mentality: The Contrarian’s Advantage
Investors find staying calm during a volatile market particularly challenging because it runs counter to the instinct to stick with the herd. It’s hard not to panic yourself when it seems like the rest of the world is panicking. While group think and herding are examples of behavioral biases that may work well for evolution, they can have a disastrous effect on investment returns. Research indicates that it’s much more difficult to focus on capturing gains when everyone else (the herd) focuses on avoiding losses.
Contrarian investing, by its nature, isn’t often intuitive, but there’s significant upside to avoiding group think. Many people feel conflicted when they go against the herd, but contrarians focus on process instead of peer pressure. A well-defined, logical process that emphasizes fundamental investment analysis can lead investors to find unique opportunities created by the herd’s indiscriminate selling. And it’s no secret that many of the world’s best investors are contrarians known for their independent thinking that often runs counter to popular opinion. Many regard the investments made by Warren Buffet during the depths of the 2008-09 Financial Crisis among the best of the modern era.
Change the Channel: How Financial News Affects Returns
Staying calm in the face of a volatile market becomes even more difficult when financial news sensationalizes every market fluctuation. Regularly tuning in to financial news can cause anyone to believe that an economic apocalypse is on the horizon.
It’s important to keep in mind that television producers often design media coverage to generate ratings, capture viewership and thus profit from dramatizing steep declines in the stock market. This can foster a false sense of control and mislead investors into believing that they can time the market by keeping up with the news. In fact, academic studies have shown that exposure to financial news actually hurts returns.
So the next time a financial news personality predicts the next recession will irreparably harm your portfolio, consider turning off the TV to focus on fundamentals. In reality, investors with the discipline to properly manage long-term stock allocations have little to fear from a recession. As the historical data shows, staying the course in the face of a recession and beyond is the most effective way to tilt the odds in favor of healthy returns.
Take a Step Back and Look at the Big Picture
Market corrections motivate people to revisit financial plans. Reviewing how investments match goals can provide peace of mind.
A critical element of financial planning is tailoring investment portfolios to goals and time horizons. For example, an investor close to retirement may find comfort in the safety of the diversification provided by bonds and other income-generating asset classes that insulate portfolios from market corrections. Young, aggressive investors who are disillusioned with short term market fluctuations may be less concerned when they view corrections in the context of a multi-decade financial plan.
Market corrections don’t feel as scary when one has put a comprehensive financial plan in place. A financial plan that charts a course of action tailored to accomplish set goals is one of the most effective tools to combat irrational investment decisions.
If you need help constructing a financial plan that can provide peace of mind during downturns in the stock market, consider working with a CFP® professional.