Nobel Prize-winning psychologist Daniel Kahneman demonstrated this with his loss aversion theory, showing that people feel the pain of losing money more than they enjoy gains. The natural instinct is to flee the market when it starts to plummet, just as greed prompts people to jump back in when stocks are skyrocketing. Both can have negative impacts.
But smart investing can overcome the power of emotion by focusing on relevant research, solid data and proven strategies. Here are seven principles that can help fight the urge to make emotional decisions in times of market turmoil.
1. Market declines are part of investing
Over long periods of time, stocks have tended to move steadily higher, but history tells us that stock market declines are an inevitable part of investing. The good news is that corrections (defined as a 10% or more decline), bear markets (an extended 20% or more decline) and other challenging patches haven’t lasted forever.
Market downturns happen frequently but don’t last forever
Sources: Capital Group, Standard & Poor’s.
The Standard & Poor’s 500 Composite Index has typically dipped at least 10% about once a year, and 20% or more about every six years, according to data from 1951-2020. While past results are not predictive of future results, each downturn has been followed by a recovery and a new market high.
2. Time in the market matters, not market timing
No one can accurately predict short-term market moves, and investors who sit on the sidelines risk losing out on periods of meaningful price appreciation that follow downturns.
Every S&P 500 decline of 15% or more, from 1929 through 2020, has been followed by a recovery. The average return in the first year after each of these declines was 55%.
Even missing out on just a few trading days can take a toll. A hypothetical investment of $1,000 in the S&P 500 made in 2011 would have grown to more than $2,900 by the end of 2020. But if an investor missed just the 10 best trading days during that period, he or she would have ended up with 44% less.
Missing just a few of the market’s best days can hurt investment returns
Sources: RIMES, Standard & Poor’s. As of 31/12/21. Values in USD.
3. Emotional investing can be hazardous
Kahneman won his Nobel Prize in 2002 for his work in behavioral economics, a field that investigates how individuals make financial decisions. A key finding of behavioral economists is that people often act irrationally when making such choices.
Emotional reactions to market events are perfectly normal. Investors should expect to feel nervous when markets decline, but it’s the actions taken during such periods that can mean the difference between investment success and shortfall.
One way to encourage rational investment decision-making is to understand the fundamentals of behavioral economics. Recognizing behaviors like anchoring, confirmation bias and availability bias may help investors identify potential mistakes before they make them.
4. Make a plan and stick to it
Creating and adhering to a thoughtfully constructed investment plan is another way to avoid making short-sighted investment decisions — particularly when markets move lower. The plan should take into account a number of factors, including risk tolerance and short- and long-term goals.
One way to avoid futile attempts to time the market is with dollar cost averaging, where a fixed amount of money is invested at regular intervals, regardless of market ups and downs. This approach creates a strategy in which more shares are purchased at lower prices and fewer shares are purchased at higher prices. Over time investors pay less, on average, per share. Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.
When stock prices fall, you can get more shares for the same amount of money and lower your average cost per share
Source: Capital Group. Over the 12-month period, the total amount invested was $6,000, and the total number of shares purchased was 439.94. The average price at which the shares traded was $15, and the average cost of the shares was $13.64 ($6,000/439.94). Hypothetical results are for illustrative purposes only and in no way represent the actual results of a specific investment. Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.
5. Diversification matters
A diversified portfolio doesn’t guarantee profits or provide assurances that investments won’t decrease in value, but it does help lower risk. By spreading investments across a variety of asset classes, investors can buffer the effects of volatility on their portfolios. Overall returns won’t reach the highest highs of any single investment — but they won’t hit the lowest lows either.
For investors who want to avoid some of the stress of downturns, diversification can help lower volatility.
No asset class has consistently offered the best returns year in and year out
Source: RIMES. U.S. large-cap stocks - Standard & Poor's 500 Composite Index; Global small-cap stocks - MSCI All Country World Small Cap Index; International stocks – MSCI All Country World ex USA Index; Emerging markets stocks – MSCI Emerging Markets Index; U.S. bonds – Bloomberg Barclays U.S. Aggregate Index; International bonds – Bloomberg Barclays Global Aggregate Index; Cash – Bloomberg Barclays U.S. Treasury Bills Index: 1 - 3 Months.
6. Fixed income can help bring balance
Stocks are important building blocks of a diversified portfolio, but bonds can provide an essential counterbalance. That’s because bonds typically have low correlation to the stock market, meaning that they have tended to zig when the stock market zagged.
High-quality bonds have shown resilience when stock markets are unsettled
Sources: Capital Group, Morningstar. Dates shown are based on price declines of 12% or more (with dividends reinvested) in the unmanaged MSCI World with at least 50% recovery persisting for more than one business day between declines. The returns are based on total returns in USD. As of 31/12/21.
What’s more, bonds with a low equity correlation can potentially help soften the impact of stock market losses on your overall portfolio. Funds providing this diversification can help create durable portfolios, and investors should seek bond funds with strong track records of positive returns through a variety of markets.
Though bonds may not be able to match the growth potential of stocks, they have often shown resilience in past equity declines.
7. The market tends to reward long-term investors
Is it reasonable to expect 30% returns every year? Of course not. And if stocks have moved lower in recent weeks, you shouldn’t expect that to be the start of a long-term trend, either. Behavioral economics tells us recent events carry an outsized influence on our perceptions and decisions.
It’s always important to maintain a long-term perspective, but especially when markets are declining. Although stocks rise and fall in the short term, they’ve tended to reward investors over longer periods of time. Even including downturns, the S&P 500’s average annual return over all 10-year periods from 1937 to December 2021 was 10.57%.
Sources: Capital Group, Morningstar, Standard & Poor’s. As of 31/12/21.
It’s natural for emotions to bubble up during periods of volatility. Those investors who can tune out the news and focus on their long-term goals are better positioned to plot out a wise investment strategy.
Bloomberg Barclays U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market.
MSCI does not approve, review or produce reports published on this site, makes no express or implied warranties or representations and is not liable whatsoever for any data represented. You may not redistribute MSCI data or use it as a basis for other indices or investment products.
Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
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Past results are not a guarantee of future results. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.