Navigating Market Turbulence: Overcoming Common Biases in Investing
Posted: 12-13-23 | Zach Terpstra
Few things test the mettle of investors like the rollercoaster ride of the stock and bond markets. Faced with uncertainty and driven by emotions, we often have to decide quickly whether to act or stay the course. This is especially true during times of extreme market turbulence when our brains hone in on any losses we may be experiencing.
In this article, we will delve into the fascinating world of behavioral biases, share historical examples of bear markets, and explore the historical performance of the S&P 500. We will examine the fear that often surrounds the lowest points of market downturns and, more importantly, discuss why sticking with your financial plan is often the better strategy. As we dissect the common justifications to sell in fearful times and the greater rewards of a long-term approach, we aim to instill confidence in creating a rational, goal-based investment strategy which can withstand the test of time.
Common Biases in Investing
There are many types of common biases that can make us our own worst enemies in investing and lead us down the wrong path—particularly during periods of market volatility when every headline inspires fear. Understanding these biases is the first step to recognizing and correcting these impulsive behaviors from derailing long-term investment success. A few of these biases include:
- Loss Aversion: Perhaps the most relatable cognitive bias is that of loss aversion. As humans, we tend to feel the sharp pain of losing money more intensely than the joy of an equal amount of gain. This fear of loss often triggers knee-jerk reactions, like selling off investments during market downturns in favor of swapping for what looks like a more attractive idea or asset class. In the real world, we too often see market participants flee to bonds when equities sour, or more recently, money markets when equities and bonds both took a hit.
- Availability Heuristic: Similarly, the availability heuristic nudges us to process information quickly, relying on the most immediate examples that come to mind. This mental shortcut can distort perceptions of how frequently certain events occur and make it difficult to stay open to alternative perspectives. It can be influenced by factors including how recently one was exposed to information, the vividness of their personal experience, or media coverage. If we consistently rely on the immediately-available experiences to make decisions about our investments, we may as well be driving our cars while only looking in our rear-view mirrors.
- Herd Mentality: Lastly, there is the powerful force of the herd mentality: the fear of missing out or being left behind. In a plummeting market, this can lead to panic selling. In exuberant bull markets, this can lead to overallocation towards riskier assets. To quote Nietzsche, “Madness is something rare in individuals – but in groups, parties, nations, and ages, it is the rule.”
Lessons From Historical Bear Markets
The markets are filled with historical examples of bear markets that shook investor confidence to the core that can illustrate these biases for us. Two of the most severe in recent memory are the Dot-Com Bubble burst at the turn of the century and the 2008 Great Recession. During those dark times, fear and panic were palpable, with many investors fearing the worst.
In both bear markets, the performance of the S&P 500, a broad measure of the U.S. stock market, experienced significant declines. The volume of losses each day grew for an extensive period in both cases, and the fear factor loomed large. From peak to trough, the S&P 500 lost 47.38% and 55.28% in the Dot-Com Bubble and 2008 Great Recession respectively. But what happened next is crucial for our discussion.
The fear and panic associated with bear markets habitually lead investors to contemplate changing strategies. The reasons are diverse, including fear of further losses and putting too much emphasis on recent experiences when making decisions. Emotional reactions can obscure rational judgment, inviting unconscious biases into our thoughts, making it challenging to stick to any long-term investment strategy.
The Importance of Inaction: Sometimes Doing Nothing Is The Right Thing To Do
Let us assume we were invested into the S&P 500 through both bear markets, and we watched passively as our losses mounted. Take a moment to reflect on what it would feel like to lose half of the value of your investments. As the value of your portfolio continues to shrink, you reach the point where you cannot take it anymore. You are not sleeping as well, conversations around money keep wriggling their way into the family, and your recent investment performance is impacting the big plans you once had. Wanting to stop the pain and gain some stability, you opt to sell out S&P 500 exposure in favor of more conservative investment-grade bonds.
By changing the components of your financial plan, you were able to gain some stability through swapping for bonds. In the second half of the Dot-Com Bubble and Great Recession bear markets, after the trough, your bonds saw gains of 31.98% and 29.26%, respectively. Great job! You stopped the bleeding in favor of finding something more stable and dependable. Your friend, on the other hand, decided to keep their long-term goals in mind and stayed true to their strategy. By choosing to remain invested, they saw gains of 90.04% and 123.46% over the same periods.
Eliminating the Emotional Rollercoaster of Investing with an Objective Approach
What these historical examples underline is the value of an objective, goals-based, long-term investment approach. While the temptation to react emotionally during market turmoil is strong, those who stay the course often fare better in the long run. Developing a plan anchored in a goals-based investment philosophy during a time of little emotion and then adhering to that plan can help navigate the stormy seas of market volatility when they pass through our portfolios.
The ability to remain calm in the face of uncertainty is a hallmark of successful investors. By understanding and overcoming behavioral biases, learning from historical examples, and embracing a long-term goals-based strategy, clients can position themselves for financial success. At Innovia Wealth, we are committed to guiding you through these market ups and downs with a steady hand and a focus on meeting your life goals.
About the Author: Zach Terpstra