Science of Fear and Staying Calm in Volatile Times

Article Summary

  • Instinct and past experiences influence how we make decisions with money. So how can you make good decisions? Behavioral finance explains our instinctive motivations and how our brains are functionally wired to influence our money behaviors.
  • While we like to believe that markets and investors behave rationally, we often see that this is not the case. We have innate mental biases that cause us to act predictably irrational, often contrary to our own best interests.
  • It takes time and effort to recognize when we are about to act from emotion or a learned script, but it can be done. We encourage you to stay the course and take comfort in the proven science of asset allocation and diversification.

 

Main Article

Walking through a grocery store during the COVID-19 crisis provides some startling observations about behavior. The financial markets haven’t been very helpful either, with daily fluctuations or volatility. While it’s tempting to want to give in to the panic and anxiety, we encourage you take some deep breaths and take a step back.

 

How Can You Avoid Making Irrational Decisions During This Crisis?

Behavioral finance studies the psychology of financial decision-making. It explains our instinctive motivations and how our brains are functionally wired to influence our money behaviors. Researchers in the fields of psychology, medicine, and economics have identified two complementary sources of motivations that influence how we make decisions with money, one involving instinct and the other past experiences.

 

Leaning on Our Instincts

While we like to believe that markets and investors are rational and therefore behave rationally, we often see that this is not the case. Innate motivations manifest in mental biases and cause us to act predictably irrational,1 often contrary to our own best interests. The stronger the emotion, the more confident we feel and the harder we react.

We have seen this play out in recent weeks with the stock market correction and the significantly increased trading volume. As financial advisors, we tell our clients to stay the course and take comfort in the proven science of asset allocation and diversification. Unfortunately, most investors do the exact opposite. For example, during the first 12 trading days in February, S&P 500 trading volume averaged 3,737,530,000 shares. Over the next 12 days, trading increased to average 5,778,110,000 (a 53% increase) as market value fell 15.6%. This is a common error that many investors make—of selling low and buying high. This happened during the 2008 downturn when many investors sold their investments at market lows, and it will happen with this crisis.

Herd behavior, where individuals imitate the behavior of a majority, is another key component of behavioral finance. We see herd behavior play out through an illusion of control bias, or the tendency to overestimate your ability to control events or the outcome. For example, we know that humans feel a loss about 2.5x stronger than an equivalent gain, meaning we’re instinctively “risk averse.” When offered a guaranteed gain or an option to take a risk to get more, we usually take the guarantee. However, when we feel we’re about to experience a sure loss, we’ll take risks to avoid that loss.

In a stock market correction, selling our investments feels like a guarantee to avoid loss. We can always buy back later at lower prices, right? Wrong, though that’s a natural instinct. The reason for our faulty logic is that the human brain doesn’t naturally process statistical probability efficiently. According to DALBAR, Inc., between 1998 and 2017, the average mutual fund investor underperformed the S&P 500, seeing a 2.3% annualized return compared to the S&P 500’s 7.7%. annualized return.2 This is a good example of how leaning into our emotions and fear causes us to miss out.

 

How Learned Financial Behaviors Shape Our Decisions

Each of us has a unique relationship with money. Research by Drs. Brad and Ted Klontz suggests that personal experiences called financial “flashpoints” help formulate our “money scripts,” or our attitudes toward money. In turn, money scripts influence our financial behavior.3

Are you a spender or a saver? Do you consider your personal wealth a private matter or do you want people to know how wealthy you are? Do you believe that having more money will make you happier? Regardless of your answers, it’s likely that you are influenced by your parents, friends, and early experiences.

Money beliefs may also become a source of spousal conflict. For example, one spouse believes saving cash during a crisis is essential while the other spouse believes spending money on a year’s worth of provisions is best to protect the family. Without understanding our own personal money beliefs, it’s unlikely we’ll be empathetic to those of our partner. Take time to reflect on your financial flash points; you might be surprised by what you discover!

When reflecting on our worst money decisions, it’s not uncommon to find some of them rooted in emotion. It takes time and effort to recognize when we are about to act from emotion or a learned script, but it can be done. Having an objective set of eyes to help explore financial options before making important decisions can help maximize your wealth and make it less likely that you’ll make a quick decision that may not be in your best long-term interest. We encourage you to use your financial advisor as a sounding board when you feel these biases creep up, and we’ll help you steer clear of making emotional investing decisions.

 

Other Resources:

Episode 28: How to Navigate a Stock Market Correction

Episode 31: Good Things Can Happen in Bad Markets

Portfolio Management to Navigate a Stock Market Correction

Asset Protection through Diversification: Revisiting an Old Friend

 

Footnotes
  1. Ariely, Dan (2008). Predictably Irrational. New York: HarperCollins Publishers.
  2. DALBAR, Inc. (2018). Quantitative Analysis of Investor Behavior(QAIB)
  3. Klontz, B., & Klontz, T. (2010). Mind over money: overcoming the money disorders that threaten our financial health. New York: Broadway Books.

   

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