indicatorAdvice for Albertans during the COVID-19 pandemic

The emotions of volatile markets

By ATB Wealth 15 April 2020 8 min read

 

Do you remember the popular 1990s film Dumb and Dumber? In his book, “The Behavioral Investor”, Dr. Daniel Crosby states that humans are more aligned with Jim Carrey’s character in that movie than they might like to admit. Dr. Crosby goes on to describe a scene from the movie when Jim’s character is told by the object of his affection that he has a 1 in 1,000,000 chance of ending up with her.

In response to hearing those impossible odds, his character beams with joy and responds “so you’re telling me there’s a chance!” Crosby makes the argument that investors, and all humans, often confuse the intensity of our longing with the probability of our winning.

Our brains can work in mysterious ways. In his book, "Your Brain on Money", Jason Zweig looks to uncover why human beings tend to work against themselves when it comes to investing. He also wrote an article on this topic where he talks about how “neuroeconomics - a hybrid of neuroscience, economics and psychology - are making stunning discoveries about how the brain evaluates rewards, sizes up risks and calculates probabilities.”1

By using imaging technology these neuro economists are able to study the brain and specifically, the changes that happen within our brains when we invest. They are finding incredible discoveries that are showing our investing brain can drive us to make decisions that are not logical but make perfect emotional sense.

Let’s take a look at some of the emotional influencers and emotions that tend to be most prevalent during market downturns or periods of volatility and what we can do to help ourselves from making purely emotional decisions.

 

Factors that affect how you feel during a volatile market

 

1. Noise vs. information

Source: ATB Investment Management Inc.


 

On a regular day, the 24-hours news cycle can have a powerful impact on our emotional responses. However, during periods of volatility, the effects are exacerbated as most of us engage more with the media, often bombarded by worrisome headlines and statistics. While it is important to stay informed and up-to-date on the situations around us, it is also important to reflect on what information applies to your long-term financial goals.

While some of the economic changes may impact our long-term investing strategy, many are temporary roadblocks that are inevitable along the way. Talking with your financial advisor can help to sort through the noise and discuss if any short-term changes are required.

For example, depending on your financial situation, an advisor might recommend a small sale from your investment portfolio to provide four months of living expenses. This can help provide cash on the side in case an emergency fund of living expenses isn’t available. Knowing that short-term expenses are taken care of can help alleviate some of the anxiety around market volatility or tough economic times. That way, the rest of your long-term portfolio remains invested and your plan is still in place.

 

2. Leading with speculation, fear and greed

Source: ATB Investment Management Inc.


 

We talk about the differences between investing and speculating in this article. To sum it up, speculation is investing in a stock or bond hoping it will increase substantially in value while ignoring the risk of losing value. It involves assuming more risk by trying to anticipate the short-term movements of a stock rather than investing over the long-term to achieve a goal.

The following quote from the late John Bogle, founder and Chief Investment Officer of the Vanguard group, sums the relationship up quite nicely; 

“Money flows into most funds after good performance and goes out when bad performance follows”.

 

We typically see the speculation relationship coming from a place of fear as markets are rapidly declining or a place of greed when markets are running up higher. When we hear of markets reaching new lows during times of volatility, we often see both fear and greed coming from investors.

 

Fear is a very powerful emotion and can cause investors to deviate from their long-term plan and, possibly, go to cash. This move can impair capital as, once the feelings of fear subside and the markets start to gain traction, the investor typically looks to redeploy.

On the flip side, greed comes into play as investors see equities that are down 40% to 50% and begin to wonder if they can make a quick profit by investing in those lower-priced equities. However, there is no guarantee some of the hardest hit equities will hit their new high.

While the slow and steady approach to wealth creation may sound boring, it is the prudent approach and the one we believe in most.

 

3. The reality of loss aversion

Source: Kahneman & Tversky


 

In 1979, psychologists Daniel Kahneman and Amos Tversky pioneered the research in loss aversion, which is the study of why humans tend to dislike losses more than they like gains. Their research showed that people are two and a half times more upset over a loss than they are happy about a similar gain.

We can see this in our personal lives. For anyone that has played organized sports, there is a tendency to remember the experience of a major loss over a big win. Our brains anchor on the loss, as it is more powerful to us than the gain.

When it comes to investing, loss aversion can shape the way investors make decisions. Investors that invested during a significant market decline and lost money could be more prone to fearful emotions during future volatility. Even the thought of losses can frame people to think they need to be more conservative in their investments than they might need to be. This can impact the ability for one to achieve their financial and life goals as they are fearful of investing and losing money.

 

Strategies for remaining calm(ish) and focused

Tuning out the noise and letting go of negative emotions can be difficult, but focusing on some of the strategies below during volatile markets can be helpful.

 

1. Your life is the best benchmark

Source: ‘Personal Benchmark’, 2014. Widger & Crosby.


 

In his book, "Personal Benchmark", Dr. Daniel Crosby outlined a study involving low-income savers and photos of children. What he found was that these savers who viewed a photo of their children before making financial decisions saved over 200% more than a control group who did not view photos. The savers who viewed the photo were motivated to focus on their goals and the visions of their family reminded them of their “why” they began investing in the first place.

Viewing your “why” before making financial decisions can help to refocus attention and ask “how does this decision impact what really matters?”. As an example, we might put a picture of the beach vacation we are saving for next to our computer so when we think about making a change to our investments, we reflect on our why and ask if this decision contributes to our life goal or not.

 

2. Invest for your own goals and not your neighbour’s

Source: ‘Personal Benchmark’, 2014. Widger & Crosby.


 

When you initially started to invest, you likely had a few goals in mind for your future wealth. It might have been sending a child to school, buying a new home, or setting yourself up for a certain lifestyle in retirement. During periods of volatility, it may seem that the media and our friends and family are talking about their investments more. It is natural to listen to how others are doing and look at our own investments more critically. While “keeping up with the Joneses” mentality can have some small benefits, it mostly gets in the way of one achieving their goals.

However, this can also cause a review of your investments, which is never a bad idea. It can lead to conversations with your advisor to ensure you are on track to achieve the goals you initially set.

It’s important to remember that there will always be somebody doing better than you. This might be because they have the capacity to take on more risk and therefore are in a portfolio with a higher allocation to equities and higher returns, or maybe they are just having a temporary pop in short-term performance while the long-term track record of your investments has actually been better over time.

While people are quick to share their investing “wins”, few are willing to share the times that a trade or investment didn’t go their way. Focus on your own goals and remember that everyone has their own investment plan in place that is unique to their specific circumstances.

Be aware of how your emotions affect your decisions

Investing is hard, let alone investing during significant market volatility. We are all likely feeling tired, unsure and maybe even a little irritable. Our brain processes information differently when we are not at our best. Becoming aware of some of the ways our brain can trick us when it comes to investing can help to limit our biases.

A simple sticky note that tells us to take a quick five-minute walk around the house or around the block before we make a financial decision in response to a headline or news story can help create space between the stimulus and our response. Creating that space between whatever is stimulating us can change our perspective. Small, simple steps can create enough space for us to re-focus our attention and approach our financial decisions with increased clarity.

 

If you do not have a financial advisor, contact us and one of our wealth representatives can help you out. We are all in this together and we are here to listen and help you make any necessary adjustments that will still keep you on track to achieving your long term goals.

 

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