Written by: Teresa J.W. Bailey | Waddell and Associates
For most investors, watching the market go down can be directly related to how much anxiety goes up.
An emotional response to extreme market volatility is normal. But letting your emotions take charge of your decision making can lead to outcomes you might regret. That’s why it’s important to understand what’s going on with your emotions so you can stay calm and respond with confidence.
The two most common responses
As a wealth strategist, I see two common behavioral responses during times of uncertainty: loss aversion and overconfidence.
Behavioral economics research shows that we experience the pain of losses about 2.5 times more intensely than we experience the euphoria of gains. This imbalance, known as loss aversion, can trigger a protective instinct when you see your portfolio deep in the red. Investors may try to shield themselves from further losses by selling out of positions after they’ve already declined. Doing that not only locks in losses but positions you to miss out on gains in the subsequent recovery.
At the other end of the spectrum lies the overconfidence bias. Investors displaying this tendency overestimate their ability to predict market movements and believe they have better investing acumen than the average investor. This can lead to excessive trading and greater risk taking, which can also be detrimental to your portfolio.
We want to navigate these moments with care and caution. Research firm Morningstar estimates that emotions “cost” investors 1.7% in returns each year. For a $5M portfolio, that equates to $85,000.
Building the foundation before emotions take charge
In my experience, the most effective approach to managing these biases is to be proactive. I find that investors who panic the least during market downturns are the ones who regularly think through both positive and negative market scenarios before they occur.
When markets are performing exceptionally well, we celebrate the gains while simultaneously reminding ourselves, “We know this won’t always be the case.”
By the same token, it’s important to keep in mind that when markets falter, that too is temporary. History shows that periods of decline are followed by recoveries. Staying the course sets you up to benefit from the recovery.
Ways to keep emotions in check
If you’re in the grip of loss aversion and have an overwhelming desire to stop the pain of a declining portfolio, start by taking a step back.
Sometimes temporarily unplugging from market updates can give you the emotional space to focus on the long term. Your financial plan is designed to weather short-term volatility and keep you moving toward your goals with confidence. We can revisit your plan at any time to ensure you’re still on track, despite market gyrations.
It can also be helpful to refer to historical data. History shows that market recoveries typically follow on the heels of downturns, rewarding patience far more often than panic. Being in cash for just 20 of the best trading days could slash your investment account returns by nearly 70%.
However, if you’re experiencing the “overconfidence” bias, the challenge is different.
In moments when you believe you’ve spotted the opportunity of a lifetime, or that you can time the market’s movements, it can be important to take a moment to slow down and have a discussion. Seek out opinions that can challenge your viewpoint or institute a “cooling off” period before making significant investment changes. Again, we’re here to support in these times too.
What CAN we do?
Sometimes, the urge to do something—anything—is overwhelming. Rather than making impulsive portfolio changes, I often recommend channeling that energy into productive financial activities that don’t upend your long-term strategy.
For instance, we can use times of market volatility to review your spending patterns and identify areas you could potentially trim without missing a beat. I find this gives people a sense of security knowing they’ll have more flexibility in the budget if the economy worsens.
Likewise, this can be a great time to review your emergency savings to make sure you have ample cash to get through three to six months of living expenses, for instance. Checking on your cash reserve can aid those worrying about future income.
Ultimately, navigating emotional investment tendencies can be less daunting when you have a strategic partner who understands your situation.
Your W&A “Chief Strategy Officer” is here to help you gain perspective when emotions run high and help you make decisions rooted in data and long-term planning. This relationship is especially important during periods of turbulence when a calm, objective voice can make all the difference in staying the course toward your long-term financial goals. Please reach out to your W&A wealth strategist with any questions and the opportunity to connect more on this topic.
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Sources: Insidebe.com, Morningstar, JP Morgan