If you’re an investor (and I hope you are), maybe it’s time for a mental check. how are you doing today? How do you feel about everything going on in the world? There are many reasons to be scared or upset:
- Stocks, including well-known blue-chip companies, are in the “bear market”.
- Bonds are being torn apart.
- Inflation is at a 40-year high.
- Interest rates are rising.
- There is a war going on in Ukraine.
- There are legitimate fears that we are headed for a recession.
Have these catalysts led you to question your investments? your financial plan? In times of stress, investors tend to fall back on emotion and the herd mentality. We default to behavior that seems “safe” but rarely serves us well. As a result, even under mild pressure, people usually make worse decisions.
One study found that bad weather affects investor behavior. Cloudy days lead to an increase in perceived overvaluation of markets for both individual stocks and the market. This prompts institutional investors to sell more on cloudy days when gloomy weather triggers gloomy sentiments. If the weather could have an effect on investor sentiment, imagine what the evening news could do.
It is essential to recognize that in the short term, emotions determine market prices. In the long run, earnings determine market prices. Described another way: Emotions drive the stock market in shorter time frames, but fundamentals drive the stock market over longer time frames. This shouldn’t be a surprise, but instead a reminder: the stock market can always be crazy. The prospect of making or losing money can lead people to act out of whack.
For example, “The Origin of Stock Market Volatility” by the National Bureau of Economic Research examined the relationship between sentiment and market performance back in 1952. Three factors explained 85% of market movements over time:
- The productivity of the economy (which only matters in the very long run).
- How much of the economy’s rewards go to domestic investors through income, dividends or profits.
- Risk aversion, which indicates how humans react adversely to uncertainty.
The study concluded that historically, about 75% of variation in the stock market in the short term can be explained by risk aversion. In other words, investors are risk averse. It’s understandable: We often avoid risks if we can. The problem is that we are not that great at measuring potential risk.
Numerous studies have shown that humans are terrible at predicting risk and future emotions. Actual experiences of events are usually less frightening than we imagined.
In his book “The Science of Fear”, Daniel Gardner talks about the “example rule”, in which the more easily we are able to remember instances of something happening, the more likely we are to do it again. experience being. This creates a fear-based feedback loop that causes us to be less likely to be killed by the things that make up the evening news. Murder, terrorism, and epidemics become more likely causes of death for us than diabetes, obesity, or heart disease.
Similarly, the more we hear about the stock market “crashing,” the more we believe it will.
This is why a financial plan is so important. This is a time- and income-specific guide, built on sound knowledge, without the stress or pressure of an impending calamity du jour. It is helpful during good times and needed during bad. As circumstances change, so does your perception of risk. Without a long-term perspective and planning based on experience, your goals are probably a function of how confident you are at the time. They change depending on how you feel that day. The goal should be that your money exceeds what you need for it. Remember, one of the most significant risks is inflationary adversity. Your income should grow over time at a rate that exceeds it.
That’s why the best time to invest in almost anything is often when it feels at its worst. But I want to make an important distinction here: a down market is not a green light for you to dump every extra dollar you invest. This is equivalent to market time. Instead, I want you to recognize how important it is to stick to your plan. If your plan has you investing extra cash flow every month, keep doing it! Don’t give your routine a break and “wait for things to get better”, which actually codes for higher prices. Choosing not to invest is the same amount of time for the market as investing more depending on what is happening at the time.
As human beings, we are emotional beings. Our emotions evolved to keep us away from danger and pain, leading to wrong choices in times of pressure. Take emotion out of your financial planning and let logic, perspective, and planning be your guide.
Steve Buren is the founder of Prosperian Financial Advisors in Greenwood Village. He is the author of “Intelligent Investing: Your Guide to a Growing Retirement Income.” He has been named by Forbes as the Best-in-State Wealth Advisor of 2021 and Barron’s Top Advisor of 2021. This column is not intended to provide specific investment advice or recommendations.