We all want to believe that we are sensible and rational people, especially when it comes to managing our money. Standard financial wisdom even states that investors make rational decisions and that markets are efficient, reflecting that rationality.
The real world, however, frequently proves otherwise. Market bubbles like the dot.com boom of the late 1990s or the Black Friday crash a decade before demonstrate that emotions get in the way of logic.
We are only human after all, and humans are subject to some psychological factors, such as bias, error and perceptual illusions.
In other words, we make our investment decisions based on gut feelings, fear and even a tendency to follow the herd. This is bad enough when markets are steady, but when they are volatile – as they may be now – it can prove catastrophic.
At Continuum, we are looking at the psychology of investing in volatile times.
What is volatility?
Volatility is a statistical measure of the tendency of a market or security to rise or fall sharply within a short period of time. Volatile markets are usually characterised by wide price fluctuations and heavy trading. They can be caused by economic news, geopolitical developments, black swan events like Covid and trends like global warming
It is fair to say that current markets are being disrupted by all these factors.
During volatile times, market prices can rise and fall dramatically. What seems a sound investment one day can drop like a stone the next. Investment can be nerve wracking.
The thing to realise is that periods of market volatility are inevitable. Markets move up and down all the time, and sometimes much more than others. Trying to time the market is difficult enough in normal circumstances. In times of rapid change and volatility it is completely impossible.
But giving into the psychological weaknesses we all share can be even worse.
What psychological factors are in play?
So, are emotions starting to cloud your investment judgement? You are not alone, and several psychological effects may be occurring.
Volatility – with our hard-earned wealth vanishing before our eyes – is frightening. As humans we can be prey to fear, which can turn into panic. On some unconscious level we may believe markets will continue to drop forever, taking our wealth with them. We know logically that investment must be a long game, but we can still find it tempting cut our losses when things start to look difficult.
This panic can cause us to us sell investments, crystalising the losses, rather than simply waiting for markets to recover.
It is made worse by the phenomenon of recency bias. In times of volatility when our portfolio values are plummeting, we look at recent events and forget that over the longer term, equity markets go up despite being hit by crises from time to time.
Failing to take the long-term view can mean making wrong decisions that ultimately cost us dearly.
We also have an inbuilt tendency to follow the herd, because we find it hard to believe that the majority could be wrong.
If we see others start selling up, we feel we should too.
Finally, we are wired to feeling the effect of a loss much more than a gain. This is known as ‘loss aversion’ by both psychologists and economists. Losses during a severe market downturn can result in some investors trying to avoid risk at any cost and switching to low risk assets.
This might avoid some losses, but it will certainly mean missing out on opportunities
So, what should you do?
Perhaps the best way to deal with the psychological side of investment is to ignore it and take a strictly logical approach.
Logically, we know that investment will be a rollercoaster, with downs as well as ups, even if emotionally we are not so sure. One way to deal with volatility is to avoid it altogether; this means staying invested and not paying attention to short-term fluctuations.
This can be harder than it sounds; watching your portfolio shrink in a falling market can be more than most can take. But we all saw how the dramatic falls after the Covid outbreak were followed by an equally dramatic recovery.
Staying invested – through the ups and the downs – is the basis of most sound investment.
Of course, you can’t just buy any stock and hold on to it for decades in the hope of making money either. You need a sound investment strategy, with a diversified spread of holdings that can maximise your returns and keep risks under control.
A financial expert who can help establish your investment strategy based on sound principles and our own objectives, timelines and tolerance for risk, is a vital asset in times like these.
At Continuum our experts can combine a thorough understanding of the basics with a watch on the market. It means that we can help you plan the style of investment portfolio you need and avoid the psychological traps which can prove so expensive when the markets are lively.
The information contained in this article is based on the opinion of Continuum and does not constitute financial advice or a recommendation to suitable investment strategy, you should seek independent financial advice before embarking on any course of action.
The value of investments can fall as well as rise and you may get back less than you invested.