If you weren't paying attention – and really, if you're reading this you surely have been – you would barely know what a wild month February was for investors.
In a period of just two weeks, the Dow Jones Industrial Average dropped more than 3,200 points, or 12 per cent of its value, before racing back to recover about two-thirds of those losses. It was a white-knuckle ride and when February's dust settled, the Dow's losing month had snapped a 10-month win streak.
Opinions on what caused the dramatic plunge-then-recovery abound (inflation, interest rates, tax cuts, Trump), but most can agree on the shared anxiety it created.
A natural question that might follow is whether the average investor's anxiety over U.S. market volatility is justified. While the rational parts of our brains would say the answer is no, the emotional parts might not come to the same conclusion. Even when we know we shouldn't worry about daily or weekly market fluctuations, it's hard to ignore the pits in our stomachs and resist the urge to check on our investments a few times a day (hourly even!)
The recent volatility of the stock market is particularly emotional because it's so easy to check the value of our stocks at the click of a button. Consider that the value of our homes also fluctuates on a regular basis. We don't experience the same level of anxiety because it's more difficult to assign an up-to-date number to it. We simply hope our homes will sell for more than we paid for them at the time of purchase. The same principle should apply to our stocks, and yet our always-on tap of market information triggers an emotional response and encourages us to consider rash decisions with every new headline.
In the past, economists have based most of their financial theories around something called "expected utility theory," which suggests that we are all rational, risk-averse profit maximizers. Research by behavioural economists Daniel Kahneman and Amos Tversky (1979) conversely found that in situations involving financial risk, people routinely disregard statistical probabilities and misjudge the odds of success or failure. Even as we repeatedly suffer the consequences of our misjudgment, we are doomed to irrationally repeat these mistakes over and over again.
Here's an example: You're looking at your investment policy statement and thinking about your risk tolerance. You decide you have a big risk appetite and opt for a portfolio that offers potential gains of 15 per cent and potential losses of the same amount. Three months pass. One day you check on your investments and discover that while things had been trending upwards, a recent market fluctuation has caused you to lose 5 per cent on your investments. Panic sets in. Do you sell?
This is a classic depiction of what psychologists like myself call the hot-cold empathy gap. It occurs when we underestimate the influence of visceral states (anxiety, hunger, pain) on our behaviour and preferences in the future. When we are in a cooler state (setting our initial risk level for our portfolio), it's difficult to predict how we will feel in a heated state (emotional response to losses). In addition to decisions about investing (Kang and Camerer, 2013), the empathy gap has been demonstrated across a wide range of decision-making scenarios. Research has revealed that we quickly change our preference for a healthy snack to an unhealthy snack when we're hungry (Read and Van Leeuwen, 1998) and we significantly underestimate how much a smoker would pay for a cigarette when they're not craving a smoke (Sayette et al., 2008). We extrapolate our current emotional state into the future because we can't imagine being hungry when we're full or wanting a cigarette when we're not in the mood. Today, it's easy to say that you will sell your stock when it reaches a certain price, but when that happens we suddenly find our decision is different than the one we planned to implement.
Our emotional state is particularly sensitive to losses, since the pain of loss far outweighs the pleasure we feel from gains of equal value. If you've ever lost a $20 bet, you know it has a much greater impact on your day than winning $20. When we see a drop in our investments, we fear this downward trend will persist and we make rash decisions that don't align with our intentions.
When it comes to investing, we're extra sensitive to losses during bull markets because it goes against our expectations. Fluctuations are a normal part of investing but when our investments go up, we anchor on that peak value and anything less than that makes us anxious. Even if the value of our investment is greater than the amount we initially invested, all future fluctuations are evaluated relative to that peak historical value.
I'll give you another example. Let's say you have an investment in Company ABC. And because the firm had very strong revenue over the 12 months, its share price climbed from $25 to $90. More recently a change of events triggers a drop in Company ABC's share price from $90 to $50. How would that make you feel? There's no logical reason to expect the price to return to $90, but by anchoring on that price you're more likely to miss out on buying or selling when you should.
But all is not lost. There are a few ways the average investor can hack their brain to absorb the anxiety of volatile markets.
Option one: Think of your investments as a long-horizon investment. If you plan to take your money out in 10 years (or more) you can expect things will change a lot between now and then. No need to make yourself crazy focusing on every extreme event when things will eventually swing up, then down and back up again. Just ride the wave.
Option two: Plan ahead to control your "hot" states while in a "cool" mood to control for your future frailties. Set up specific rules for what you will do if a particular scenario occurs, called if-then intentions. It may sound something like, "If I lose 20 per cent on my portfolio, then I will turn off my computer." Make sure to tell other people about your if-then intentions so they can keep you accountable.
Option three: Compare yourself with everyone else. Recognize that if your stocks have dropped, so have your neighbours' and they're likely just as anxious. Your rash decisions multiplied by all your neighbours' rash decisions only fuel market volatility, creating a more turbulent cyclical response. So if you really want to be proactive, comfort your neighbours.
Misery loves company.