In times of market volatility, investors can get gripped by fear and uncertainty. In recent weeks, the markets have been doling out a rocky ride, stoking investor fears that can lead to some pretty terrible financial decisions.
Listening to financial media pundits and Wall Street soothsayers can make just about anyone think the financial world is coming to an end on any given trading day. However, no one (and I mean no one) can see into the future, and what you hear on TV and read about in the news has to be taken with a grain of salt because media companies are trolling for views, clicks, and ratings, after all.
So, how should you resolve your own “flight” instincts when it comes to your investments? If you find yourself feeling nervous and anxious about your money, do you make a fear-based judgment call or do you resist and stay the course?
At the risk of sounding obnoxiously cliche, “knowledge is power.” The more you know, the better prepared you can be to stifle any fear-driven reactions to your investment performance. Therefore, read on for a refresher on how market cycles work, how fear can impact your long-term financial success, and what you can do to protect yourself from making emotionally-based financial decisions.
How Market Cycles Work
Here’s the thing. Markets fluctuate. They go up. They go down. However, properly diversified investment portfolios are built to withstand the ‘messy middle’ that characterizes the very real and very normal market correction we are in the midst of today.
In fact, Fidelity Investments found that over a 35-year period, the market has fluctuated greatly. Fidelity’s research also revealed that even in what seemed like some of the worst times to be an investor actually turned out to be some of the most rewarding times to stay invested or start:
During the past 35 years, the market has experienced an average drop of 14% from high to low during each calendar year but still had a positive annual return in more than 80% of the calendar years in this same period. The historical data also reveals that what seemed like some of the worst times to get into the market turned out to be the best times. The best 5-year return in the US stock market began in May 1932—in the midst of the Great Depression. The next best 5-year period began in July 1982, amid an economy in the midst of one of the worst recessions in the postwar period, featuring double-digit levels of unemployment and interest rates.
Moreover, the historical data shows that, without fail, markets that go down will go back up and vice versa. There is no such thing as an unending upward market trajectory. That is not normal and should not be the expectation of any investor.
How Fear Can Impact Your Long-Term Financial Success
When investment values lose money, it can cause legitimate fear. The Smithsonian explains how fear is a powerful emotion that causes defense or “flight” instincts to kick-in and results in a flee response out of protection. They also share how fear creates mental distractions as a defense mechanism so that the brain can process fear, but this means that the ability for sound reasoning is limited under this emotional situation.
As people, it’s not always easy to remain objective about money decisions when fear enters the room. Trusting “instincts” is often touted as a strength, which may be the case in certain situations, but when it comes it investing it is rarely accurate. When it comes to financial decisions, objectivity should be the prevailing influence over how you act versus how you feel. Why? Because as it turns out, the average American is really terrible at making investment decisions.
Even the most pragmatic of long-term investors can find him or herself weary and impatient. The Dalbar study found that psychological factors represented half (50%) of the reason for investment underperformance. The remaining causes for underperformance have to do with capital availability – either not having enough or needing it for other, non-investment purposes.
Over the 20-year study, the single largest contributor to underperformance over time has to do with behavioral biases. Dalbar defined nine of the irrational investment behavior biases as:
- Loss aversion: When your fear of loss leads you to sell out of the market at the worst possible time.
- Narrow framing: When you make a decision about one part of your portfolio without considering the effects on your entire financial well-being.
- Anchoring: When you become too preoccupied with past performance that you can’t or won’t adapt to a changing market. In other words, you won’t make changes when it is necessary.
- Mental accounting: When you separate performance of investments mentally to justify success and failure. This limits your view of how your investments are performing as a whole.
- Lack of diversification: When you believe your portfolio is diversified when it is actually highly correlated in a certain pool of assets.
- Herding: When you follow what everyone else is doing. This notoriously leads to “buy high/sell low.”
- Regret: When you become paralyzed to take action as a result of the regret you feel from a previous failure.
- Media response: When you buy what the media predicts is a good investment without any consideration for your personal situation or how and if it actually makes sense.
- Optimism: When you are overly optimistic about the assumptions you make about your investments, which can cause extreme disappointment if/when reality differs.
Of these nine investment behavior biases identified in the study, the biggest ones that lead to underperformance are loss aversion and herding, which tend to function together, compounding the damage of poor decision-making.
Furthermore, independent research conducted by Morningstar, Inc. reinforces that when investors try to time the market and pull out prematurely based on fear, they can wind up missing some of the biggest gain opportunities, which can have a substantial negative impact on one’s long-term financial trajectory. Their research concluded that missing the 5, 10, 30, and 50 biggest gain days would lower your total return by approximately 35%, 52%, 81%, and 91%, respectively.
What You Can Do to Protect Yourself From Making Emotionally-Based Financial Decisions
Fear-based financial decisions don’t lead to smart money moves. Instead, a snap reaction to market performance often creates far greater danger for your financial outlook than if you would have stayed invested in the first place.
To stop yourself from making short-sighted investment moves, here are a few things you can do to protect yourself:
- Work with a fiduciary financial advisor. Having an objective professional who creates a customized investment savings plan for you and helps you stick to it is one highly effective way to save you from yourself. You have access to someone who can address your fears reasonably, put your mind at ease, and continue to educate you through the process.
- Give yourself a “cooling off” period. If you’re not working with a fiduciary advisor, then you have to set boundaries for yourself. That means, committing not to make any drastic money moves based on a whim or rush of emotions. Sleep on it. Wait a week. Let yourself get through your emotions before you take any action.
- Learn what you don’t know. Education and knowledge about finances and markets can quell a lot of the fear that falls over you like a wave when you read an alarming headline or see a drop in your portfolio value. You will have to become more of the expert on historical trends so that you can see the forest through the trees.
Let fear ignite a conversation or generate important questions you have about your financial preparedness, but don’t let fear make your financial decisions for you.