Key takeaways
- Emotional investment reactions to sudden market declines and increased volatility tend to be driven by human behavioral biases, such as loss aversion.
- Historical patterns of investor behavior show that surging equity market volatility can cause some investors to make hasty, emotionally charged investment decisions that often turn out to be regrettable.
- Recognizing innate biases may help prevent investors from tampering with a well-crafted portfolio strategy during periods of severe market turmoil.
Why your emotions can get the best of you
Our brains and behavior patterns have evolved under different types of living environments over hundreds of thousands of years. During the past decade, the study of the influence of psychology on the behavior patterns of investors and the subsequent effect on the markets—known as behavioral finance—has gained credibility among both academics and financial market participants.
As human beings, we generally have a stronger preference for avoiding losses than for making gains when evaluating the risks of an investment—a behavioral bias known as loss aversion. Because of this behavioral tendency, we generally respond and react more vigorously to the onset of negative events that could trigger painful losses in our portfolios than we do when faced with a similar likelihood that could lead to performance gains.
The strong influence of loss aversion helps explain why many investors disregard predetermined investment strategies when unforeseen, negative events occur. Such events fuel our fears of incurring losses, and cause an internal battle to break out between the logical side of our brains and the emotionally driven side, the latter of which often prevails. While rushing to sell our positions may serve to help quell our emotions, in hindsight the timing of such decisions also can turn out to be suboptimal.
Exiting near the peak of the 2008–09 global financial crisis
For example, near the peak of the 2008–09 global financial crisis, a record net amount of money flowed out of equity funds after the stock market plummeted. The Lehman Brothers bankruptcy filing in September 2008—the largest in history—triggered a stock market sell-off that led to record monthly equity fund outflows in October 2008. When the market hit new lows a few months later in February/March 2009, another large wave of outflows followed. As it turned out, many loss-averse investors reduced or liquidated their exposure to stocks near a market bottom, and when it actually turned out to be a pretty good time to be owning stocks . From the peak month of liquidations (October 2008) through the end of June 2010, the stock market rallied 16%, compared to near-0% returns on cash-equivalent investments. Further, because only a fraction of the massive outflows seen during the fourth quarter of 2008 and in early 2009 trickled back into equity funds throughout the subsequently robust 2009 rally, market-timing investors had either missed the market's abrupt turnaround or reentered the market at higher price levels.
Investors who stayed invested in stocks during the peaks in equity fund liquidations (Oct. 2008 and Feb./March 2009) and held on through May 2010 would have fared better than those who exited during the peaks in fund liquidations and missed some or all of the market's recovery.
In retrospect, the 2008–09 global financial crisis was arguably one of the most unnerving events facing investors since the Great Depression era. However, what these equity fund flow patterns show is that the timing of investors who get rattled by market volatility and choose to shift in and out of the stock market tends to be poor. The next time an unusual negative event creates a spike in market volatility, investors might recall that periods of turmoil are not unusual. Over the long run, the equity market has proven resilient throughout many crises.
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