February’s sudden and sharp stock market correction shocked capital markets, sending many retail investors out of stocks and onto the sidelines. For the week ending February 7, U.S. stock funds saw a record $23.9 billion withdrawn by investors in favor of perceived safe havens.¹ What is defined as a drop of 10% or more from 52-week highs, market corrections, happen fairly often. On average, corrections occur about once a year – so why does this one feel so different? The answer is simple… it’s been a while. Recency bias is real and investors have been spoiled by an extended period of low volatility with no market corrections. With the recent spike in volatility it is a good time to revisit the all important “cycle of investor emotions” and a few behaviors to avoid during market downturns.
During periods of elevated market volatility, investors tend to let emotion cloud their judgement, resulting in costly mistakes. Because market cycles are nearly impossible to predict and stock price movements are essentially random, it is imperative for investors to keep their emotions in check. Here are a few of the most common behavioral traps caused by emotional decision-making:
- Reluctance/Loss Aversion – most investors fear taking a risk and getting it wrong more than they fear missing out. Couple that with loss aversion – the belief that we will feel more emotional pain from losing a certain amount than the pleasure we get from an equivalent amount of gains – and you have a recipe for avoiding risk all together and sitting on cash.
- Overconfidence – when optimism morphs into greed things don’t often end well for investors. This was summed up best by Sir John Templeton, when he said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” In other words, when markets are rising, don’t become overconfident and take risks beyond your tolerance.
- Timing the Market – attempting to move in and out of markets is a losing battle, particularly when timing decisions are made on emotion. Trying to buy and sell based on short-term price movements sounds great in theory, but it rarely works. Instead, we should focus on building a well-diversified portfolio, including asset classes with investment returns that move up and down under different market conditions.
- Chasing Performance – most all human beings suffer from the fear of missing out and investors are no different. When an asset’s price moves higher and higher, the bandwagon looks more and more appealing. The problem is once we jump on board, generally it’s too late. Instead of focusing on the past by chasing past-performance, we try to find market and economic trends that haven’t already been exhausted.
Investors can quickly become their own worst enemy when allowing emotions to take them for a ride. Constructing a personalized plan and portfolio around your goals for investing, your personal risk comfort zone and time horizon can go a long way towards keeping you calm during the best and worst of times.