“The world faces a new pandemic” or “Hurricane Joffrey causes an oil shortage in the US” both impact the financial markets. Yes, these events are out of our control, and they will influence market movements for an undetermined period. However, are uncontrollable events like these the main drivers of the stock market?
An expert in the financial market, who runs financial models and has worked at a bank for over 30 years, bought ABC stock yesterday; another person who knows nothing about the market bought XYZ stock yesterday because his favorite comedy influencer bought it. Considering they bought similar amounts, their impact on the market was similar. Humans, with different backgrounds and knowledge, impact the markets every day by buying and selling stocks; this is why understanding behavioral finance is so important. Also, understanding which behaviors to avoid and follow will benefit you as an investor in the long term.
Buying low and selling high! Or… the other way around. Timing the market can be difficult even for finance experts. Even though it is tempting to sell a stock at its all-time high and rebuy it when it reaches a low point, most people get that wrong and would benefit more from staying invested the whole time. Let’s use the S&P 500 as an example. Seven of the best 10 days of the S&P 500 occurred within two weeks of the worst 10 days of the index. If you manage to time an S&P 500 drawdown correctly, what would be the odds that you would also time perfectly the moment to rebuy it? More than that, what are the odds that you would get that right more than 2 or 3 times? I believe we can both agree that the chances are low. That said, the S&P 500 returned 10.20% per year on average in the last 20 years. Let’s say you hypothetically invested $10,000 in the S&P 500 index in 2003; today, you would have around $67,275 in your account. Quite a reasonable amount. However, if you made several trades on the S&P 500 index during those 20 years and, as a result, missed the best 10 days of the index, your total amount would drop more than 55% to $30,150. Not as good.
What helps us understand market behavior and hold our urge to sell a product at the wrong time or price? Aside from analytics, understanding the various biases can lead us to do it. The first one to be mentioned is loss aversion bias, which can be explained by feeling the pain of losses more intensively than the pleasure of gains. Usually, this bias causes investors to sell their investments during market downturns to avoid further losses. As we learned, most of the time, the market tends to have its best days after a market downturn. What can investors do to avoid this loss aversion bias? Setting and following clear goals should be the primary solution to this problem. Questions about being a short-term or long-term investor, what you want to buy with the money invested, or even how much you want to earn over a given period. Categorizing what you want to use that money for always helps you to understand the final objective. If you are saving for your child’s college education in 10 or 15 years, you have time and can bear temporary losses.
Herd behavior is another common bias among investors who sell their positions during market euphoria. During uncertain moments, such as a pandemic or a war, people tend to sell their positions, fearing that the market will enter a panicking downturn and take far too long to recover. Even though historically, the US markets have shown remarkable consistency in bouncing back from drawdowns (average recovery of less than 6 months), investors still fear and prefer to move to cash or other safer products. For this bias, the secret can be to avoid checking your portfolio too often. Instead of checking your portfolio daily or weekly, check your investments every quarter, semester, or year. Checking portfolios often will increase anxiety and leverage chances of making impulsive decisions that might deviate from your end goal.
Overconfidence and confirmation bias are two factors that can lead to missed returns. Firstly, it’s important to remember that nothing is 100% certain; markets are unpredictable, and nothing is ever too obvious. Overconfidence is not a good strategy. It’s crucial to research the situation, discuss it with various people, and avoid letting confirmation bias dominate your decision-making. Confirmation bias will only allow you to process information that aligns with your pre-existing beliefs. While it’s fine to agree with multiple articles, it’s essential to acknowledge and remember that risks are always associated with your decisions. In this context, diversification is a suitable solution. Asset allocation and informed diversification allow you to express your views on asset classes you feel confident about (by increasing exposure to them) while still paying attention to other asset classes that might offer different sources of returns. Uncorrelated assets such as equities, fixed income, private equity, private debt, commodities can help you maximize long-term investing. The higher the level of diversification, the smoother the ride, and the fewer changes needed over the years.
In conclusion, understanding the psychological factors that influence investment decisions is crucial for long-term success in the financial markets. By recognizing and mitigating biases such as loss aversion and herd behavior, investors can make more informed and rational decisions. Staying invested, setting clear goals, and maintaining a diversified portfolio are key strategies to navigate market volatility and achieve financial objectives. Remember, patience and discipline are your most powerful tools in the journey of investing.
Works Cited
– Bogle, John C. The Little Book of Common-Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. John Wiley & Sons, 2017.
-J.P. Morgan Asset Management. “Guide to the Markets.” J.P. Morgan, 2023.
– Odean, Terrance, and Brad M. Barber. The Psychology of Investing. Pearson, 2013.
– Shefrin, Hersh. Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Oxford University Press, 2002.
