Investors have access to more knowledge and technology to guide their market decisions than ever. So why are many of them still making the same mistakes?
Despite the stellar market rebound since the October 2022 lows, a lot of people have chosen to sell rather than stay invested. Net stock redemptions persist even as the S&P 500 has climbed significantly. In spite of everything, it’s not hard to find someone who buys high and sells low. What gives?
Human beings are afraid of what they don’t know. It doesn’t matter how much historical data, expert opinions and advanced analytics you put in front of someone. The innate human response to uncertainty will often override logic.
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Fear and herd behavior lead investors to act impulsively during downturns, prioritizing short-term survival over long-term strategy. If investors can’t resolve the psychological barriers to sound investing, they can’t bridge the disconnect between knowledge and action.
The root of investor panic
Investor behavior during downturns is often driven by fear and loss aversion, a concept rooted in behavioral finance. that losses are psychologically twice as powerful as gains, causing even seasoned investors to make irrational choices.
When market volatility spikes, the instinct to “cut losses” overrides long-term strategies, leading to poorly timed exits that can lock in losses and miss subsequent recoveries.
The worst part is that more information doesn’t solve the issue. In fact, it can make it worse. Real-time market information and instant access to your personal portfolio will often conspire to make you all the more sensitive to short-term fluctuations and open the door to unwise decisions.
Understanding the historical context of market cycles can help investors resist panic. Historically, markets have weathered significant downturns and emerged stronger over time.
The October 2022 low is a recent example of how staying invested during turbulent times can lead to exceptional returns.
According to JP Morgan Asset Management’s Guide to the Markets, the best and worst one-year total return for the S&P 500 was 47% and -39% respectively. But, the best five-year rolling period was 28% and the worst was -3%. This is the reason that financial advisers tell investors that equities are long-term investments.
Financial advisers play a critical role in reinforcing this perspective. Regular communication, clear explanations of investment strategies and personalized reassurance can help clients focus on long-term goals rather than short-term noise.
Advisers can also help by setting realistic expectations and making it clear how much downside a particular mix of assets may experience by using historical data.
I often tell clients that our job is to help them go from being an investor who is likely to panic and sell during a downturn, to one who sees it as a time to invest.
How to stay the course
- Focus on goals, not headlines. Regularly revisit your financial goals and how your investment strategy supports them. Ignore the temptation to act on sensational news or market speculation.
- Limit portfolio checks. Checking your portfolio less frequently can reduce emotional reactions to daily market movements.
- Stay diversified. A well-diversified portfolio reduces risk and provides a smoother ride through market turbulence.
- Reframe volatility as opportunity. Instead of fearing market downturns, view them as chances to buy quality investments at a discount. Long-term investors often benefit from capitalizing on periods of market weakness.
- Lean on expertise. Work with a trusted financial adviser who can help provide perspective, prevent rash decisions and adjust strategies as needed.
Managing expectations can also contribute to helping investors avoid making mistakes. Advisers can help by setting realistic expectations and making it very clear how much downside a particular mix of assets may experience by using historical data.
I often tell clients that our job is to help them go from an investor who is likely to panic and sell during a downturn to one that may actually invest during those times.
Market downturns are inevitable, but panic is optional. While the abundance of tools and information available today can empower investors, it also requires discipline to avoid emotional decision-making.
By understanding the psychological forces at play and implementing strategies to counter them, investors can position themselves for long-term success, even in challenging markets.
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