The Psychology of the Stock Market and Investment Decisions
Investors are people, not robots, and people can be swayed by emotions like fear or excitement. And in the investing world, that can be a big problem.
There is an incredible euphoria when an investment portfolio is doing well. Performing at higher-than-average levels can make investors feel invincible. But without the emotional lows that the market can cause, these highs could not be possible.
Many key factors contribute to the movement of the market, and investors need to be aware of these considerations in order to thrive in today’s volatile environment.
Multiple factors move markets
Interest rates are a driving force of movement in both the stock and bond markets. Rising rates have an adverse impact on bond prices as well as a dampening effect on stock prices. Unfortunately, many average investors underestimate the impact of rate movements on their investments until after the impact is felt.
Similarly, the 24-hour global news cycle and the speed at which information is disseminated serves to increase market volatility and create exaggerated reactions. The never-ending focus by news organizations on global events can contribute to an unsettling and uncertain atmosphere for many.
Essentially, psychological factors of investing can greatly influence outcomes on a personal and collective scale in the financial markets. While both emotionally based investment decisions and the shared impact of market swings can have negative impact on returns, there are ways in which investors can make rational investment decisions that may potentially strengthen their portfolios in any stock market environment.
Emotionally based investing decisions
In most cases, individual investors who allow their emotions to dictate their investment decisions will suffer from poor long-term results. In my perspective, there are two types of emotional reactions the average investor can experience.
The first emotionally driven decision comes from Fear of Missing Out (FOMO). These investors will chase stocks that appear to be doing well, for fear of missing out on making money. This leads to speculation without regard for the underlying investment strategy. Investors can’t afford to get caught up in the "next big craze," or they might be left holding valueless stocks when the craze subsides.
FOMO can lead to speculative decision-making in emerging areas that are not yet established. An example of this is the recent cryptocurrency mania. Many investors, perhaps stoked by fears that their co-workers and neighbors would “get rich quick” without them, chased crypto stocks with unproven business models. As rational behavior began to set in and crypto stocks plummeted, inexperienced investors were left holding the bag.
The other emotion investors often face is Fear of Losing Everything (FOLE). While investors do not want to be left out, a more powerful emotion comes from the fear that they will lose all of their investment. When market volatility causes large swings in the stock market, people can become unnerved, causing them to sideline their investments to avoid a big sell-off or stock market crash.
This behavior was most notable in the wake of the 2008 financial crisis. Investors pulled their money out of the stock market as a reaction to the market sell-off, only to subsequently miss out on recouping losses in the dramatic recovery.
Collective impact of stock market swings
The 24-hour news cycle exacerbates irrational, emotionally based investment decisions as information is disseminated almost instantaneously, thanks in large part to the internet. Since major global stock markets overlap in market hours, investor reactions to global events are reflected in real time. And when that reaction is particularly negative, it can generate a domino effect of sell-offs across regional stock markets with a seemingly never-ending cycle of market adjustments and news updates.
Unfortunately, selling begets selling, which during a market correction may create a downward momentum on stocks that can be difficult to break. The exaggerated moves of a volatile market can rock the confidence of inexperienced investors who fear they will lose the money they have worked so hard to accumulate.
Further complicating the landscape are professional short sellers, such as hedge funds or algorithmic trading programs, which can take advantage of selling situations by shaking out investors with a flood of additional selling pressure.
Ways to make rational investing decisions
No investor in the history of stock markets has batted 1.000 when investing. While the general rule of thumb is to avoid emotional decision-making, investors should also not chase speculative "get-rich-quick" fads.
Diversify, diversify, diversify.
One of the most important fundamental principles for any investor is to diversify their portfolio. The goal of skilled investment managers is to drive the best risk-adjusted portfolio returns with a balance between sectors. Diversifying a portfolio mitigates downside risk. In general, avoid speculative sectors completely, but if an investor wants to dabble in areas of higher risk, they should limit their exposure to no more than a few percent of their overall portfolio.
Stagger buy and sell decisions.
Another tactic an investor can use to limit emotional investing is to stagger buy and sell trades. For example, if an investor wants to own 500 shares of a particular stock, a prudent approach might be to purchase 200 shares at the current price level.
The next buy order could be placed at 5% to 10% below the current level, and the remaining shares could be purchased at 20% below the current level. If the stock price moves up after the initial trade, the investor will still achieve gains on 200 shares and may move onto the next investment, thereby alleviating some of the FOMO effect.
If the price moves down, the investor would acquire more shares at a lower price. The same approach should be used in establishing sell points for stocks. Instilling this type of discipline and trading methodology may allow investors to better manage their portfolios and achieve higher risk-adjusted returns over the long term. If a stock is falling because the company or sector was failing, it wouldn’t be a good investment thesis in the first place. It is best to avoid making the first purchase or cut losses if the first trade had already been made before the thesis changed.
Have a solid investment approach.
Finally, having an investment approach to help combat emotions is critical. Dividend-paying stocks can be an important tool in helping investors avoid emotional decisions. They are typically less volatile and tend to be more resilient during challenging market environments.
Additionally, limiting exposure to commodity-centric stocks like oil and precious metals, which can be more volatile and heavily influenced by geopolitical factors, should help investors avoid emotional responses.
The bottom line for investors
It is important to have a sound and actionable investment thesis based on objective metrics rather than speculation. Holding to a strategy will guide an investor during periods of volatility, helping to resist the urge to panic sell during a correction or chase a hyped-up stock trading at unsustainable levels.
Patience is critical, and investors who remind themselves of why they invested in the first place will better keep their emotions in check. In the same breath, recognizing when to change an investment strategy requires an objective approach. Incorporating these simple steps while also avoiding emotional decision-making will almost certainly produce better outcomes for investors over time.
Securities offered through Kalos Capital Inc., and investment advisory services offered through Kalos Management Inc. Caliber Financial Partners LLC is not an affiliate or subsidiary of Kalos. Member FINRA/SIPC. The opinions expressed are as of the date of publication and are subject to change. This material is not intended to be relied upon as a forecast or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Past performance is no guarantee of future results. Kalos Capital Inc. does not provide tax or legal advice. Please consult with your tax and/or legal advisor for such guidance.