There are many risks in today's market environment: a bear market, rising interest rates, high inflation, and fears of a recession.
How you respond to these disruptions matters more than you might realize.
While finding good investments is important, how you behave as an investor largely determines your long-term success.
The financial research firm DALBAR has consistently found that fund investors underperform not because they make poor investment choices but because they behave in ways that aren’t in their best interests.
The current market environment can trigger behavioral missteps. Here’s what to watch out for:
Emotional investing can put your plans at risk
All investors strive to make rational, informed investment decisions that are consistent with their financial goals, but in times like this, emotions can override logic.
Daniel Kahneman, who won the Nobel Prize for his work on behavioral finance, identified two systems at work when people make decisions and wrote about them in his best-selling book, “Thinking Fast and Slow.”
System 1 is emotional and reactive. It leads us to jump to conclusions and act out of fear. In System 1, our minds jump directly from “stocks are falling today” to “the market’s crashing.”
System 2 is analytical and deliberative. In bear markets, System 2 thinking might include a longer look back at market history to see that market declines are a normal part of long-term investing, and that bear markets tend to be much shorter than bull markets.
You can see how these two systems can lead to different outcomes. System 1 panics when the market’s down and puts your long-term goals at risk, while System 2 thinks longer term and weighs the evidence. Ideally, you’d rely on System 2 to make investment decisions, but in turbulent conditions as we’ve seen this year, System 1 thinking can take over.
Biased thinking can lead you off course
We are all susceptible to unconscious biases that can affect our investment results. We assume that what’s happened lately will continue to happen (behavioral economists call this recency bias), and we tend to give more credit to information that supports what we already believe (confirmation bias).
Given this year’s market decline, for example, you might assume stocks will keep falling, so you start paying more attention to bearish market forecasts. This could lead you to focus more on protecting your portfolio from future losses than investing in a way that helps you participate in the market’s long-term gains.
Perhaps the most common investor bias is loss aversion: investors are primed to want to sell out of stocks at the first sign of weakness (to prevent losing money) and then they tend to wait to buy back in when they believe losses are unlikely, even though this cycle doesn’t help them get ahead.
Struggling to stay on track in turbulent markets?
Emotions can be hard to control, and most of us are blind to our own biases, which is why it’s often beneficial to work with an investment adviser who can help you keep your biases at bay, stay focused on your investment goals, and make investment decisions that help you move forward.
We have been helping investors stay on track through difficult market conditions for more than 50 years. Set up a time to talk with an adviser about how you’re investing in this environment.