Think about it. When there is panic, everyone rushes to the exits. It happens in the markets too: Fearing the unknown because of COVID-19, investors have rushed out of the markets, causing massive volatility. Running away from bad news may seem perfectly natural but this kind of behaviour may hurt your finances in the long run.
With its wild ups and downs, the markets can feel like a roller coaster these days. “It’s an interesting analogy,” says Preet Banerjee, investment journalist and behavioural finance consultant. “If you were on a roller coaster and you were half-way through the ride, the last thing you’d want to do is to get off that roller coaster until it came to an end.”
He says that what investors may be experiencing is something behavioural economists call “loss aversion.” Behavioural economics is a field of study that looks at how our brains make financial decisions. The theory behind loss aversion says that people feel losses far more deeply than they feel equivalent gains.
“We are roughly twice as sensitive to losses as we are to gains of a similar magnitude. So the emotional response of losing $10 feels twice as painful as finding $10 makes you feel good,” says Banerjee.
In a market like this, that means investors may feel a very sharp emotion over their investment losses, but selectively forget or downplay the possibility that markets may rebound healthily at some point in the future. The best investing advice is to buy low and sell high. In reality, our natural urges can often cause us to do the opposite.
“A lot of evolutionary biologists would point out that for more than 99% of our evolution, all we had to do was know how to stay alive until the morning,” says Banerjee. “That means we focused on a series of short-term decisions. Therefore we are really good at making knee-jerk reactions based on limited information so that we stay alive.”
In this light, there can be a natural impulse to take some sort of action to prevent further losses, Banerjee says. “It’s a fight or flight response to stimulus,” he says, “making you think that you have to do something.”
That’s understandable. You have a lot riding on that money and have worked hard to earn it, but Banerjee says that choosing to hold the course can in fact be an action in itself and may not be as passive as you might think. “Sticking to the plan is doing something and that takes resolve,” Banerjee says.
Going back to that roller coaster analogy, he says if you were to sell and get off that ride now, then you would have the additional task of figuring out when to get back on board. Banerjee says this is a fairly consistent trap that investors fall into. “What happens is many investors wait one or two years to see good returns before they have the confidence to get back in,” Banerjee says. By then, he says, “they would have missed out on those returns.”
One way to address this evolutionary trap is to take an opportunity to reframe your finances. One stock may be down, but another may be up. Maybe you’ve lost thousands of dollars, but perhaps it only represents a small percentage of your portfolio. Are you still up over the book value of your investments? If you have a balanced portfolio that’s diversified, it may not be moving as wildly as the 100% equity indexes quoted in the news might suggest. Also, while your portfolio might show losses in the last quarter, how has the performance been when compared to the last five years?
Banerjee suggests also trying to reframe your perspective from short-term to long-term. “One of the ways that you can do that is by reviewing your long-term plan if you have one,” he says. “You want to avoid making reactive, short-term decisions with your long-term goals and plans.”
By reframing your financial picture, it may help you to sleep better and make more confident financial decisions.