What a Bear Market Does to Your Brain

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.

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.

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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.

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.