Mr. Market at the Psychologist, Part 3: Here’s How Much Those Knee-Jerk Reactions Cost

David Frost // Blog, Market Psychology


February 11  

This is part three of a series on market psychology and how your emotions might affect your strategy. Click here for part one on decoding the market’s state of mind. Click here for part two on sentiment and fundamentals.

One of the greatest risks to your assets today is news headlines. Human beings are emotional creatures who often respond to bad news by panicking, but we don’t have to let our emotions drive our investing decisions. Studies show investors who can step outside their emotions when making decisions see better performance from their portfolios. This may sound like it’s more easily said than done, but it is possible to put an end to those knee-jerk reactions you may have when the news flow points to market turmoil.

Investing with your emotions is your loss

First, let’s discuss the numbers. Morningstar Behavioral Science head Stephen Wendel published a study on investor panic in the Journal of Financial Planning toward the end of 2018. In it, he estimated the cost of investing with your emotions rather than with a level head. Based on his findings, he states that investor panic results in a loss of 8% to 15% of assets over a decade, assuming “standard risk capacity-based asset allocations and risk preference-adjusted glide paths.” On the other hand, after adjusting to a more behavioral-focused approach leaving emotions out of the equation, he found a 17% to 23% increase in assets over a decade.

He noted that there is a distinct lack of empirical data on panic and market exits. Thus, to come up with these estimates, he simulated investor behavior by defining and describing four different types of investors, with two being emotionless and two being emotional. During times of market turmoil, the two emotional investors would panic and exit the market.

Based on his simulations, the emotional investors saw annual losses of 100 to 154 basis points. This is in line with another study conducted by Geoffrey Friesen and Travis Sapp in 2007, who estimated annual losses due to poor market timing at 150 basis points per year.

Beware headline risks

It’s important to understand what happens when investors panic. Wendel also described the stages investors go through when they panic about their investments.

The first stage is volatility. A news headline or event triggers volatility in an investment. For example, you may hear that a company you have invested in has posted disappointing earnings results. It may be tempting to panic and sell your investment, even though you have done your research on the company and remain convinced that this is just a temporary hiccup rather than a sign of a bigger problem.

By the time you hear about the earnings results, the stock has already plunged, so you have lost all the gains you captured during the run-up in the stock price. The wise thing would be to wait to sell your shares until the stock price has recovered, but this may be difficult to do. You will then have to decide whether to give in to the panic you feel because everyone else is selling or whether to stay the course and ride out the storm.

If you invest emotionally, you will probably have a knee-jerk reaction to that weak earnings report and end up selling while the stock is low. To add make the situation even worse, you may find yourself buying shares of the same company later after the stock price has recovered because everyone else feels good about it. If you follow all these steps, then you just sold low and bought high, erasing some of your assets in the process.  

Strategies to avoid emotional investing

It may seem impossible to avoid panicking and exiting positions at the top instead of the bottom, but there are some strategies to help you avoid this. One strategy recommended by the Securities and Exchange Commission and industry experts is dollar cost averaging. This strategy works because you are consistently putting more money into the market throughout the year instead of making decisions based on what’s happening in the market.

Dollar cost averaging involves investing the same amount of money several times throughout the year instead of just when the bulls are carrying the market up and away. Some investors choose to invest on a weekly, monthly or quarterly basis. The key benefit of this strategy is that it forces you to buy low and sell high. By investing the same amount of money, you automatically buy less of an asset when the market is higher and more of an asset when the market is lower. This frees you up to sell holdings when the market is higher, so you have more money to invest when the market falls.

An important strategy to follow whether the market is up or down is portfolio diversification. It’s never wise to invest all or most of your capital in the same asset class. A properly diversified portfolio is better able to withstand the ups and downs of the market because one asset is gaining in value while another is falling. Diversifying also forces you to stick with your previously decided allocation, keeping certain percentages in stocks, bonds and other asset classes, no matter what the market is doing.

Fight emotions with research and knowledge

It’s also important to do your research on your investments (or pay an advisor to stay on top of things for you). This is especially true of stocks because the more you know about the companies you invest in, the better you can make decisions about what to do with them when panic strikes. Sometimes it is better to cut your losses, but generally speaking, what goes down will come back up—assuming the company isn’t facing bankruptcy or some secular challenge that’s changing the industry in which they operate.

Understanding the relationships between asset classes is also an important part of the investing process. This will enable you to time your asset purchases based on what the market is doing. For example, gold prices tend to start rising when an economic expansion is nearing its end. Gold is seen as a store of value during more difficult times, so it’s only natural for investors to pile in when it looks like turbulent times are ahead.

Research is also an important part of avoiding the herd mentality, the topic of the next article in this series. Whenever the bulls are running on any particular asset, it’s important to question how high is too high. When will you be pressing your luck ahead of a pullback? Buying just because everyone else is buying is also a form of investor panic, although in a positive sense. The problem is that when you run with the herd, you’re buying an asset after it has already risen instead of getting in while the price was lower. We will discuss this further in the next article.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost