The psychology behind irrational investing

Of all the academic fields that explain what moves markets, including economics, international relations and sociology, psychology is arguably the most accurate.

It is a scientifically proven fact that during periods of market uncertainty, investors make irrational decisions to avoid making losses.

Studies show that the pain of losing money is twice as severe as the emotion of earning, winning or gaining money. This phenomenon is known as loss aversion, whereby real or potential loss is perceived by individuals as psychologically or emotionally more severe than the equivalent gain. It is this phenomenon that makes market volatility so dangerous for investors.

Volatility within markets, is only dangerous for investors when there is an immediate requirement for the capital that is invested. For example, if an investor holds $100,000 in the S&P 500, which has just fallen by 18% YTD, and they need access to this capital, the volatility is indeed dangerous and would resemble a near 20% loss should they withdraw their holding. However, if the investor does not require access to the capital for the next 15 years (as is commonly the case in a pension account) the risk brought about by the volatility is undoubtedly far lower.

The first lesson from above is to not invest on a short-term basis if you need immediate access to the capital. The shorter the window investors give themselves, the greater the risk they are bearing. Conversely, investors with a long-term view reduce their risk significantly.

How loss aversion leads investors to ignore conventional wisdom

There is always a great deal of debate among investors during market downturns. However, there is one fact which is not up for debate:

  • Global financial markets have recovered from every crash in history 

The above is a well-known fact, but despite that, investors continuously make irrational decisions during periods of volatility. 

Excluding investors who require immediate access to their capital, it makes little to no sense to sell at a loss during a period of short-term volatility. So, the question is, why do investors repeatedly make this mistake? The answer is loss aversion.   

The pain inflicted on investors during a market downturn is severe. When markets turn red, investors begin checking their portfolios daily. They become haunted by frequent news stories about how this market downturn is different from the others. And they begin to wonder exactly how bad the situation could get.

Within loss aversion is a theory called myopic loss aversion. This has to do with investors being extremely sensitive to short-term losses. If someone is myopic, they become near-sighted. This means that they can only properly focus on things close by, and everything in the distance becomes blurry. During a market downturn, many investors become myopic, losing sight of their long-term strategy.

A worldwide health crisis

The Coronavirus pandemic was an excellent example of this. The world had not faced a worldwide health crisis for generations. So, investors naturally thought the worst. Everyone was talking about the pandemic. It was the only news story at the time.

As a result of the pandemonium, even the most seasoned investors began selling positions at a loss due to myopic loss aversion. However, as has always been the case with markets, they recovered, and in this example, they recovered extremely quickly.

The current market crash is creating a string of news stories that contribute to myopic loss aversion. These include an invasion on continental Europe, by a global superpower with nuclear capabilities, sky-high levels of inflation around the world and supply chain pressures creating bottlenecks in China. All of this is too much to look past for many investors.

How investors can protect themselves from myopic loss aversion

There are a few ways investors can protect themselves from myopic loss aversion. The first is to maintain a long-term view by looking at the long-term performance of markets. Throughout history, markets have experienced bumps along the road, but always in a positive direction.

The second is to avoid checking your portfolio on a daily basis. While smartphones can often make it irresistible to take a quick look at your holdings, it’s best to check your portfolio’s progress quarterly to avoid the temptation to make short-term snap decisions. The third tip is to remind yourself regularly why you began investing and monitor your progress towards that goal. Ensuring you are meeting your savings targets during a market downturn will help you pick up securities at a lower price.  

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