Advertisement
Investor Psychology

What a Bear Market Does to Your Brain

Normal market cycles can stir up your emotions and push you to invest unwisely, but being aware of your behavioral biases can help you focus on your long-term plan.

Most investors are aware that the stock market rotates through a number of phases over the course of an economic cycle, with various sectors and industries doing better than others at different times. Well, investors pass through a number of emotional stages during the course of a market cycle—often to our detriment. Being aware of the behavioral biases that can hold sway at different periods can go a long way toward keeping you—and your port­folio—on track.

Start at the beginning, just before a bull market takes off. Having been mauled by a bear market, investors have a strong aversion to loss, which research has shown is twice as painful as a gain is pleasurable. A phenomenon known as anchoring makes it hard to let go of the negative events that precipitate or accompany a bear market. Persistent worries about a double-dip recession or another market downdraft make it easy to fall prey to status quo bias: You’re largely out of the market, and inertia and procrastination make it hard to get back in, just when the opportunity is greatest.

Advertisement - Article continues below

In the middle stages of a bull market, the bad memories start to fade. FOMO—fear of missing out—draws you in. You see your friends making money, and stocks are all over the news. The next thing you know, you’re part of the herd, subject to the strong pull of group behavior. At this stage, “investors view the last bear market as a one-time aberration, blamed on a housing bubble or a financial crisis,” says Jim Stack, of InvesTech Research. They believe that everything is now under control.

Advertisement
Advertisement - Article continues below

Confidence kills. In the later stages of a bull market, investors become overconfident in their own judgment and abilities, underestimating risk and overestimating expected returns, says Stack. FOMO intensifies. People put more money in stocks than they otherwise would, as greed takes over and long-term risk management goes out the window.

Two other biases contribute to speculation in the later stages of a bull market, says Victor Ricciardi, a finance professor at Goucher College and co­editor of the book Financial Behavior: Players, Services, Products, and Markets. A tendency toward representativeness leads investors to draw extended conclusions from a limited sample of evidence—as in, stocks will keep going up just because they have been. Familiarity bias causes investors to concentrate their assets in the stocks and sectors that have been doing the best while ignoring underperformers, which leads to a lack of diversification.

Advertisement - Article continues below

As a bear market begins to materialize, anchoring again comes into play. The most recent market top becomes the anchor, or the target that investors believe they need to reach in order to sell their shares, says Stack. Finally, as the downturn crescendos, herding behavior comes back in full force. It generates brutal sell-offs that carry stocks far below fair value, leading to investor capitulation and wholesale dumping at the bottom. About 60% of a bear market’s declines take place in the final third of the downturn, notes Stack. And then the cycle begins again.

You can do a few simple things to lessen the effects of behavioral biases on your portfolio. Keep a long-term chart of the stock market handy to help you maintain historical perspective. Determine an asset allocation that is both diversified and appropriate to your risk tolerance and stage in life, and then rebalance on schedule, no matter what the market is doing.

If you’re saving for a long-term goal, dollar-cost average by investing a fixed amount on a regular schedule. That takes the emotion out of buying and lowers your average cost per share. If you’re in or close to retirement, keep enough cash to cover one to two years of living expenses so you can ride out any downturns.

Advertisement
Advertisement

Most Popular

18 Things You Can't Return to Amazon
Smart Buying

18 Things You Can't Return to Amazon

Before tossing these items into your virtual shopping cart, be sure to read Amazon's return policy first.
September 17, 2020
Election 2020: Joe Biden's Tax Plans
taxes

Election 2020: Joe Biden's Tax Plans

With the economy in trouble, tax policy takes on added importance in the 2020 presidential election. So, let's take a look at what Joe Biden has said …
September 18, 2020
7 Foreign Countries Luring Americans to Work Abroad During the Pandemic
careers

7 Foreign Countries Luring Americans to Work Abroad During the Pandemic

Work remotely – really remotely – in these appealing destinations offering special visas for American workers.
September 18, 2020

Recommended

Retirees, Create An Emergency Fund for Rental Property
Business Costs & Regulation

Retirees, Create An Emergency Fund for Rental Property

Build a cushion to protect your income from an unforeseen crisis.
September 15, 2020
25 Small Towns With Big Millionaire Populations
investing

25 Small Towns With Big Millionaire Populations

Large concentrations of high-net-worth households are found in surprising locales across the U.S. Check out the latest list of American small towns te…
September 15, 2020
Bankruptcy Filings Chalked Up to COVID-19
investing

Bankruptcy Filings Chalked Up to COVID-19

Bankruptcy filings pile ever higher as the COVID-19 pandemic continues to weigh on the American economy. Here are 24 big-name companies that have soug…
September 11, 2020
What Does the Upcoming Election Mean to Your Investments?
investing

What Does the Upcoming Election Mean to Your Investments?

For smart investors, the surprising answer may be very little. Here’s why, and what you should do (and not do) as election season heats up.
September 11, 2020