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Emotional Investing is Risky Business: A Lesson in Behavioral Finance

Jonathan M. Gardey, MBA, CFA®, CFP®

President and Chief Executive Officer

If you are a seasoned investor, you know how terrible it feels to watch your portfolio take a hit during bouts of market volatility.  It doesn’t make it any easier when every news headline seems to be sounding the alarm on a potential crash or recession.  The reality is you are not alone in reacting negatively to this news. In fact, old and new investors alike follow pretty predictable patterns of emotion when it comes to market cycles.  Turns out we’ve been reacting the same way for centuries!

In this newsletter, we explore how psychology affects our investment decisions and what we can do to curb the impulses that could damage us most.

Some things in life go better together—fine wine and cheese, hot dogs and summertime baseball games, and tax planning and investment management, to name a few. Emotions and investing, however, are not one of them. In fact, there is an entire field of study known as Behavioral Finance that supports it.

Behavioral finance is a unique area of study that encompasses finance, psychology, behavioral economics, experimental economics, and sociology. It uses psychology to explain the gap between how investors ought to act verses how they actually act. In theory, investors know they ought to do a number of things—spend less than they make, save and invest, avoid pulling out of the market in a downturn, and more. What investors actually do is often far less rational and emotions are to blame.

The original study of investor behavior dates as far back as 1912 to Selden’s Psychology of the Stock Market, but its formal origin is arguably with Daniel Kahneman’s and Amos Tversky’s 1979 Prospect Theory: A Study of Decision Making Under Risk.

In their pivotal research, Kahneman and Tversky uncovered two critical conclusions:

  1. Investors make financial decisions based on subjective, rather than objective, reference points (i.e. emotions rather than reason).
  2. Investors are naturally loss averse and will do whatever it takes to protect their gains (even when they know better).It seems that when it comes to our money, emotions tend to get the best of us.

The Cycle of Investor Emotions

We see Kahneman and Tversky’s conclusions acutely reflected in the cycle of investor emotions, which follows a sine wave and goes a little something like this: As the market moves higher and higher, optimism boils over into thrill and thrill into euphoria. Investors feel great in this bullish environment and are often willing to take on even more market risk.As the market begins to fall, though, emotions shift. Denial is followed by fear, fear by desperation, and desperation by panic! This is when investors throw their hands in the air and “sell everything” (and at rock bottom prices, nonetheless). (See Figure 1 and Figure 2 below)Figure 1. Cycle of Investor Emotions. Modern Times Investors. 11 May 2021

Figure 2. Market Emotions Cycle. Seeking Alpha 11 May 2021

The most painful part about investors prematurely selling investments is they often sell off right before the market’s lowest low—which means they are generally on the sidelines when recovery begins and by this time, they are skeptical and tend to stay out of the market until conditions are significantly improved (i.e. when prices are higher than what they sold for). Now they have sold at rock bottom prices, miss out on recovery gains, and pay a higher price for the same securities to get back in.

How Much Impact Does This Have on Long-Term Gains?

For better or worse, emotions are often the number one driver of our behavior, and financial behavior is no exception. But, what many investors fail to realize, missing the long-term investing “forest” for the short-term “trees,” is that emotional investment decisions cause them to lose out on significant returns.

According to Dalbar, Inc., a Massachusetts-based research firm that has been studying the behavior of mutual fund investors and market returns since 1994, the average equity fund investor earns far less than the market indices suggest.

  • For the twenty years preceding December 31, 2015, the S&P 500 Index averaged 9.85% a year while the equity fund investor earned a market return of only 5.19%.
  • The average investor over this time period earned only half (53%) of what the market provided over this period!

And the 2018 DALBAR statistics[1] weren’t any better:·      

  • In 2018 the average investor underperformed the S&P 500 in both good times and bad, lagging behind the S&P by more than 100 basis points in two different months.
  • Poor timing caused a loss of 9.42% on the year compared to the S&P 500 index that retreated only 4.38%. The losses of the individual investor were nearly double the S&P 500 index.

What Kahneman and Tversky uncovered about investor behavior in 1979 hasn’t changed. Humans have a natural “loss aversion” that makes us feel or perceive potential investment losses more acutely (roughly twice as bad) as the positive emotions we feel about potential gains. The idea of loss can turn our insides out and cloud our rational judgement.

How to Avoid Making Emotional Investment Decisions

When media headlines are running rampant with stories of doom and gloom and friends and neighbors are all touting how many gains they saved by pulling out of the market, it may be hard for you not to wonder: should I be doing the same thing?

But, research has proven time and again that letting emotions steer the financial ship is risky business. Here’s what to do instead:

1. Forget About Your Portfolio

While regular review and rebalancing is often necessary, resist the urge to check on your stocks too frequently (daily, weekly or even monthly). Doing so may lead to more frustration than elation and you may even find yourself enticed to make an emotionally driven decision regarding your investments.

2. Let Your Advisor Do the Worrying

One of the most beneficial things your advisor can do for you is to help you keep perspective when markets get tough. After all, your advisor is here to see you succeed. If he or she thinks you need to sell, they will certainly let you know. If you need someone to lean on and voice your concerns, your advisor is here for that, too. Remember that your advisor has your best interest in mind and will guide toward the best course of action for your situation.

3. Learn More about Market History

Removing your emotions from your investment decisions is easier said than done, but learning what historically happens in each market type (bull and bear markets) can help you better prepare emotionally for downturns. Understand how long bull markets and bear markets typically last, the trends that feed into each market type, and historic recovery times. This can help you separate yourself from the near-term environment and focus on the bigger picture.

Keeping Perspective

Whether you’re new to the stock market or a seasoned investor, it can be hard to keep your emotions in check. Try your best not to get caught up in the public hype or media frenzy and lean on your advisor for support. Remember, you may not be able to control your feelings about a market downturn, but you can control how you react to them. Don’t be one of the Dalbar’s “average investors” who let emotional cycles hinder their long-term plans.  

At Gardey Financial Advisors, we help individuals and families work through this natural cycle of emotions when market movement causes concern. We also design our client portfolios to be able to withstand these natural market cycles when combined with regular re-balancing and ongoing monitoring. If you are in need of a financial ally we encourage you to visit our site and learn more about our services.

Important Disclosure Information

Gardey Financial Advisors DisclosuresPlease remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gardey Financial Advisors (“Gardey”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Gardey. Please remember to contact Gardey if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.  To better understand the nature and scope of the advisory services and business practices of Gardey, please review our SEC Form ADV Part 2A, available via the SEC's website @ www.adviserinfo.sec.gov.  (Click on the link, select “Investment Advisor Firm,” and type in the firm name. Results will provide you both Part 1 and 2 of the Gardey Financial Advisors Form ADV.  Statistics from third-party sources are deemed to be accurate but have not been confirmed by Gardey.

[1]https://www.dalbar.com/Portals/dalbar/Cache/News/PressReleases/QAIBPressRelease_2019.pdf 11 May 2021