Improving Investor Behavior: Mindsets During Volatile Times

roller coaster

Note

This article originally appeared in the Denver Post, June 26th, 2022.

If you’re an investor (and I hope you are), it’s probably time for a mental check-in. How are you today? How do you feel about everything going on in the world? There are many reasons to be fearful or upset:

  • Stocks are in a “bear market,” including well-known blue-chip companies.
  • Bonds are getting pummeled.
  • Inflation is at a 40-year high.
  • Interest rates are rising.
  • There’s a war in Ukraine.
  • There are legitimate fears we are heading for a recession.

Have these catalysts caused you to question your investments? Your financial plan? During times of stress, investors tend to fall back on emotion and a herd mentality. We default to behavior that seems “safe” but rarely serves us well. As a result, under even mild pressure, people generally make worse decisions.

One study found something as innocuous as poor weather impacts investor behavior. On cloudy days there is an increase in the perceived overvaluation of the markets for both individual stocks and the market. This leads institutional investors to make more sales on cloudy days when gloomy weather triggers gloomy emotions. If the weather can have a measurable effect on investor sentiment, imagine what the evening news can do.

It’s essential to recognize that in the short term, emotions determine market prices. Over the long term, earnings determine market prices. Described another way: emotions drive the stock market over shorter timeframes, but fundamentals drive the stock market over longer timeframes. This shouldn’t be a surprise, but instead, a reminder: the stock market can always get crazier. The prospect of making or losing money can cause people to act in bizarre ways.

For example, research on investor behavior[1] examined the correlation between emotion and market performance back to 1952. Three factors explained 85% of the market’s moves over time:

  • The productivity of the economy (which only matters over the very long term).
  • How much of the rewards of the economy end up going to household investors through income, dividends, or gains.
  • Risk aversion, which indicates how humans react unfavorably to uncertainty.

The study concluded that historically, roughly 75% of the variation in the stock market over the short term could be explained by risk aversion. In other words, investors resist risk. This makes sense: we often avoid risk if we can. The trouble is we’re not all that great at measuring potential risk.

Numerous studies have shown humans are terrible at forecasting risk and future emotions. Actual experiences of events are typically less scary than we imagine them.

In his book The Science of Fear, Daniel Gardner talks about the “Example Rule,” wherein the more easily we’re able to recall examples of something happening, the more likely we perceive it to happen again. This creates a fear-based feedback loop that causes us to overestimate the likelihood of being killed by the things that make the evening news. Murder, terrorism, and pandemics become more likely causes of death for us than diabetes, obesity, or heart disease.

Similarly, the more we hear about the stock market “crashing,” the more we believe it will.

This is why a financial plan is so important. It is a time and income-specific guide, built on sound wisdom, without the stress or duress of an impending disaster du jour. It is helpful during good times and a necessity during the bad. As circumstances change, so does your perception of risk. Without a plan based on long-term perspective and experience, your goals are likely a function of how confident you are at the time. They change based on how you feel that day. The goal should be to have your money outlast your need for it. Remember, one of the most significant risks is the headwind of inflation. Your income must grow over time at a rate that outpaces it.

That’s why one of the best times to invest in almost anything is often when it feels the worst. But I want to make an important distinction here: down markets are not a green light to dump every spare dollar you have into investments. That’s the equivalent of timing the market. Instead, I want you to recognize how important it is to stick to your plan. If your plan has you investing extra cash flow each month, keep doing it! Do not pause your routine and “wait for things to get better,” which is really code for higher prices. Choosing NOT to invest is as much timing the market as investing MORE based on whatever is happening at the time.

As humans, we are emotional creatures. Our emotions evolved to keep us from danger and pain, leading to poor choices in times of duress. Take the emotion out of your financial plan and let logic, perspective, and a plan be your guide.

[1] https://www.nber.org/papers/w19818 Origins of Stock Market Fluctuations

Steve Booren

Steve Booren is the Owner and Founder of Prosperion Financial Advisors, located in Greenwood Village, Colo. He is the author of Intelligent Investing: Your Guide to a Growing Retirement Income and a regular columnist in The Denver Post. He was recently named a Barron's Top Financial Advisor and recognized as a Forbes Top Wealth Advisor in Colorado.

More Posts

Follow Me:
LinkedInYouTube