The arrival of market volatility on the scene in the first few weeks this year has been sudden. Like Kramer from Seinfeld entering a room, this grand entrance into 2022 was abrupt and very much present. There is no ignoring it.
Catching investors off guard, market volatility triggers investor emotions which can be tricky to manage. If you have been shaken by the volatility in the markets in the first few weeks this year you are not alone.
It’s not uncommon for investors to make irrational decisions during periods of volatility. To move successfully through volatile times, one must actively remove emotion from the equation of investment decision making.
Human nature is to feel uneasy when markets drop, but it’s how we rise above to allow our rational mind to make the decisions rather than being driven by emotions that matters. A good first step is to recognize these emotions exist. Once acknowledged, we can work to set them aside and move forward in a calculated manner.
Each investor carries with them some hidden biases which can impact their success as an investor. These biases, while present all the time, can be amplified in volatile markets. Investor psychology and behavioral finance are certainly interesting areas studying the complexities of investor behaviour.
Each investor’s emotional responses are a bit different. It can be hard to recognize your own biases.
Learning about six common investor biases may allow you to step back and look at your own emotions as they pertain to investing and recognize one or more of these.
This person is living in the moment of what is happening at the present time and as a result believes what has been happening lately will keep happening. This person has lost the perspective of time. They may see a recent time frame of volatility, market declines, sensationalized media headlines and forget everything that has happened in the past several years and the longer-term frame of reference. They project recent activity into what they believe will happen going forward. They have lost their ability to step back and see the long-term picture.
Loss Aversion bias
This person becomes paralyzed by the fear of losses and disproportionately afraid to stay the course in order to acquire gains. The pursuit of gains becomes secondary to the fear of losses. It is human nature to have a stronger emotional response to losses than gains. It hurts the investor emotionally to lose money nearly twice as much as it would feel good to gain the same amount. The feeling of loss stays in the memory much longer than the elation of gain. This investor may become obsessed over a rough patch in the market and the fear of loss becomes their guiding motivation often to their own detriment.
Over confidence bias
This occurs when the investor has an inflated sense of confidence in their intuitive reasoning and judgments pertaining to their investment decisions. They may prefer their own perspective over that of a qualified specialist believing in some way that their perceptions are somehow superior regardless of what industry experts are saying. As an example, this person may be adamant there is either great opportunity or looming peril in one specific area despite there being no expert evidence to support this level of belief.
Framing occurs when someone makes investment decisions depending on how the information is presented without considering the overall context. This is the person who may miss the forest for the trees looking at one small section so closely they miss the overall big picture or objective. An example could be someone who looks at something with such narrow context (i.e. fixation on a particular asset, sector, fee structure, style) they have become convinced this is the primary guiding principle at the expense of looking at all elements and the broad scope of diversification.
This person becomes a victim of groupthink and mimics the thoughts or actions of a larger group regardless of whether these thoughts and actions are rational or irrational. This person is quick to jump on the bandwagon of the next best thing or what they believe to be a hot tip. This person can become a market chaser and forget the strategy of their long-term investment goals.
Anchoring happens when someone uses one key piece of information to make their rationale from, and forgets to put other pieces of information into the equation in their decision-making process. Once they have settled on an arbitrary piece of information they see as predominantly key, this becomes their guiding reference point. They may become disproportionately obsessed one piece of the puzzle (i.e. sector, expense ratio, geographical distribution etc) and lose sight of the importance of looking at everything all together. This is like the tail wagging the dog. Anchored to one small point means a fraction of the overall information has a disproportionately large role in the final decision.
Corrections and pull backs are a normal part of market activity. We have had corrections in the past and will continue to have them in the future. It’s a normal part of long-term market cycles. No, we can’t predict them with certainty and yes, they often catch us by surprise. It’s just the nature of the market.
Historically speaking markets have always bounced back from corrections in the long term and eventually reached new highs. In order for investors to manage well through market downturns it is important to resist pressing the panic button and keep focus on long term goals. This too shall pass.
Column appeared in This Month in Elgin magazine, February 2022 edition
Stephanie Farrow, BA., Certified Financial Planner, Stephanie has over 29 years' experience in the financial services industry, a diploma in Financial Planning from the Canadian Institute of Financial Planning and Certified Financial Planner designation. Stephanie has been writing a financial column for local business magazine Elgin This Month/This Month in Elgin since 2010. Stephanie and her husband own Farrow Financial Services Inc. About our Farrow Financial Team.