During periods of sustained growth, investing can begin to feel like a one-way street, and it’s easy for a sense of complacency to set in. However, when market volatility strikes and portfolio losses begin to add up, investors have a tendency to overreact – taking action for action’s sake – even when such actions are counterintuitive to their investment strategy and long-term financial goals.
This behavior is actually a well-studied field of economics known as behavioral finance, which seeks to understand how psychological influences and biases affect the behaviors of investors.
However, with an awareness of these subconscious biases, you can better navigate the troubled waters of market volatility and help improve your overall decision-making process as it relates to your portfolio.
Before diving into the specifics of behavioral finance, it helps to take a step back and understand why it matters.
According to research conducted by DALBAR and published in the 2020 Qualitative Analysis of Investor Behavior report, the average investor often has returns that are lower than most benchmarks or indices. As the report notes, “Since 1984, approximately 70% of Average Investor underperformance occurred during only 10 key periods in which investors withdrew their investments during periods of market crises.”
In other words, while investors have a tendency to negatively react to perceived bumps in the markets, the majority of these reactions occur in periods of notable market volatility. Awareness of this habit is the first step toward curbing it. So what sorts of actions should investors pay particular attention to?
Key investor behavior that can limit portfolio performance
An awareness of how psychological influences can affect decision-making can go a long way toward helping investors avoid engaging in such behavior. Three key behaviors worthy of a deeper understanding include:
Loss Aversion. A field of study known as prospect theory has shown that investors feel the pain of losing money more powerfully than they feel the positive effects of gaining the same amount.
This means that investors have a tendency to focus on doing what they can to avoid losses, even if the actions they take aren’t in alignment with their long-term goals and investment strategy.
When markets experience bouts of volatility, loss aversion can lead investors to move their money to what they perceive to be more stable holdings, like cash or money market accounts. However, this can be a very short-sighted move. That’s because even during periods of market declines, there still tend to be days of positive performance. And missing only a fraction of these positive days can have long-term consequences on portfolio performance.
Mental Accounting. Sure, a dollar is always worth a dollar – right up until it isn’t. Investors often treat money differently based on factors like how it was earned or which account it’s held in. This is the main idea behind mental accounting. This is why individuals might treat money received from an inheritance differently than money earned through a job. Similarly, an investor might choose to spend a bonus on a vacation rather than investing some of that money for the future. Awareness of this tendency can help you to curb such actions.
Anchoring. Anchoring is a behavioral bias in which a psychological “benchmark” is used as the basis for decision-making. For example, investors might “anchor” their portfolio value to their initial principal investment. If volatile markets cause their portfolio to fall below the value they have “anchored” to, they may feel compelled to take action, even if that action is not based in logic and may be detrimental to their long-term goals.
Similarly, during periods of market volatility, investors might “anchor” to the idea that markets will only continue to decline, forgetting about the tendency for positive days noted above, or even the likelihood of an eventual market recovery. This can lead to investors severely understating their tolerance for risk and making decisions that might hurt the growth potential of their portfolio when positive days or recovery occur.
Be aware of your bias
Behavioral finance can have a very real impact your decision-making, which many investors may not even be aware of.
However, by understanding your emotions and how they are affected by the current market environment – especially during periods of market volatility – you can help to limit the negative long-term impacts this bias may have on your portfolio.
Always remember: don’t let short-term market trends influence your decision-making when working toward your long-term financial goals.