Managing your stock market psychology

In theory, investment decisions should be calm, rational, and supported by careful research. But that’s just not how human nature works. When markets go wild and the value of your life savings changes overnight, it’s hard not to get emotional. These emotions can lead to some costly mistakes. 

“Stocks are unusual because people want to buy more and take more risk when prices are up, and less when prices go down,” says Michael Finke, professor of wealth management at the American College of Financial Services in King of Prussia, Pa. “It’s the opposite of how we deal with buying other products.” If buying high and selling low sounds like an unprofitable investment strategy, it certainly is.

According to a 2022 report from Dalbar, a financial services market research firm, the typical investor in an equity fund underperformed the S&P 500 by more than 3% a year over the past 30 years. On a $1 million portfolio, that’s more than $30,000 a year lost unnecessarily versus keeping it in an S&P 500 index fund. “Investors give up value through poor timing. The worst thing they do is sell during downturns,” says Finke.

The more volatile markets get, the harder it is not to feel emotional, especially if you’re facing a steep loss. Investors have been on a roller coaster lately, from the sudden market collapse in 2020 due to COVID-19 to a booming 2021 when the S&P returned nearly 27% to the 2022 bear market. But investors seem to be resisting the impulse to react emotionally.

Michael Liersch, head of Wells Fargo’s Advice and Planning Center in New York City, says this time, these market swings have motivated people to become savvier investors. “Usually when there’s a lot of market volatility, people either put their head in the sand or they take action too quickly. Today, people are approaching their decisions with a high degree of deliberation, which is unusual.” 

Liersch, who has a Ph.D. in cognitive psychology, hypothesizes that the COVID-19 crash gave people such a wake-up call that they’re paying more attention to their investments. “Investors were more prepared for the 2022 bear market than they typically would have been.”

Finke finds that experience influences investment decisions both negatively and for the good. “Older investors and retirees are less likely to pull money out or change their allocation than younger investors during a downturn.” In other words, they are more likely to stick with their plan and avoid panic selling. 

However, Finke warns “when older investors do change their retirement portfolio during a downturn, they are far more likely to reduce stock allocations significantly, especially if they had a lot of stock pre-crash.” When retirees do make an emotional change, it tends to be a big one. Those who sold after the March 2020 crash likely missed out on some sizable gains later in 2020 and in 2021.

To protect your portfolio, here are some common mental pitfalls that cost investors and how to avoid them.

Common investor mistakes

Changing the portfolio inappropriately

Finke says there are two types of investors who get in trouble: those who change their portfolio constantly in reaction to market swings as well as those who don’t rebalance often enough. “Those who don’t rebalance after a bull market end up with too much in stocks. When the markets correct, these investors might be tempted to pull out altogether because they took a bigger loss from being overweighted.”

Instead, you should set a target portfolio allocation for retirement, like 60% stocks and 40% bonds. Then pick a schedule to check your allocations and rebalance as needed, like quarterly or annually. Finke believes “target date funds have been a game changer for this problem as they automatically rebalance.” There are target date funds for workers as well as for retirees, which continue to rebalance and become more conservative further along in retirement.

Selling winners too early, holding losers too long

Finke finds that investors like to sell their winners to lock in their gains while holding onto their losers, with the hope of breaking even or making a future gain. He says the opposite approach usually makes more sense. “There tends to be momentum with stocks. Today’s winning stock is more likely to be tomorrow’s winning stock, too, as other investors get in. The same is true in reverse for losing stocks.”

This approach also works out better for taxes. If you’re invested in a taxable brokerage account, you’d owe more capital gains for selling stocks with a large gain versus those with only a small gain, whereas selling stocks for a loss gets you a tax deduction. “Your primary focus should still be on building a well-diversified portfolio,” Finke says. “But all else being equal, focus on selling shares with the lowest gains or biggest losses first.” 

Not understanding your investments

Peter Casciotta, owner of Asset Management & Advisory Services of Lee County in Cape Coral, Florida, says new clients don’t know what’s in their portfolio far too often. “It’s only when they’re losing money do they start really looking at their statements. They realize they had more risk in their portfolio than they thought.”

Make sure you understand why you built your portfolio the way you did, based on the asset allocation, risk level, and investment selection. Consider discussing with your financial/investment advisor if you have one or finding one for a portfolio review if you don’t. “With my clients, I talk to them every quarter. They know their income needs, their strategy. If you know what’s going on, it helps ease the panic,” says Casciotta.

Getting swept up in market frenzies

During periods of market volatility, Casciotta finds that people listen to the news and get too caught up in the action. “Everyone hops on the bandwagon. They get a little greedy and there goes their diversification. Their portfolio ends up overweighted in riskier assets like stocks and real estate.”

Casciotta says investors should be mindful of the temporary nature of market swings. “For every boom, there’s going to be a bust,” he says. “For every bust, there will be another boom. This shouldn’t be a surprise.” To avoid overreacting to the next frenzy, consider cutting back at the source: Watch less market news, delete the trading app from your phone and skip the golf course stock bragging sessions.

Feeling hyper-loss aversion

A loss tends to bring more pain than the boost you feel from an equivalent-sized gain. Liersch says retirees feel this pain even more than the typical investor. “When you’re not making an income, you aren’t able to replenish your balance sheet after a loss. There’s a temptation to take the risk level down dramatically, like by going all cash with the hope to later time the market.” He points out that when you’re all in cash, inflation degrades your savings. People, he says, tend to wait too long to reinvest, missing the big upswings.

If you’re feeling especially nervous, Liersch recommends taking some minor action. “Add a little bit more cash to your portfolio or make a small trade to get it off your chest. You’ll feel like you’ve done something without changing your entire strategy unnecessarily.”

Not being realistic about spending down assets

Finke worries that many retirees believe they can get through their entire lives without spending down their nest egg. “That’s just not realistic, especially today with no pensions.” He says that people get emotionally attached to their starting retirement number and end up taking too much risk if they try to earn enough to avoid spending their savings. 

They also get more aggressive to make up for a market loss. Finke says you should instead, be realistic about the idea that you likely will need to spend down your portfolio over time; don’t get caught up trying to stay at your original reference point by investing more aggressively.

Mental tips for investors 

Keep a cash reserve and non-market investments

Casciotta recommends keeping three to six months of living expenses in a cash reserve to reassure yourself during market downturns. He also suggests having a system to replenish the reserve as needed. “You should have a balanced portfolio with fixed and equity investments,” he says. “In a down market, the money comes from fixed investments so my clients don’t sell at a loss. When the market booms, then we tap the equity accounts.”

Besides bonds, Casciotta recommends using a fixed index annuity to help generate this income. These insurance contracts pay a return based on some market index, like the S&P 500, but cap your gains and limit your potential losses, so you don’t usually lose money during a downturn. For even more safety, you could use a fixed annuity. A fixed annuity pays a guaranteed monthly income that doesn’t change up or down based on market conditions. 

Don’t take risks you’re not comfortable with

“The whole reason you’re investing in stocks is to earn more money to live better,” says Finke. “But if the thought of losses has you so stressed you can’t sleep at night, then your stock allocation is probably too high for your risk tolerance.” By reducing how much you hold in stocks, you’ll reduce the total risk in your portfolio so you are less likely to see large losses. Finke does acknowledge that by making this adjustment, your average return and income will likely be lower. However, the tradeoff could be worthwhile if it means you’re more comfortable with your investments.

Plan with a collaboration partner

During times of stress, people get overloaded and make more financial mistakes. For example, people are more likely to miss bill payments even if they have the money. Liersch thinks this problem is made worse by the tendency by couples to divide household responsibilities, with only one typically handling the finances.

“If you’re the one investing, you really want to be sharing information about why you’re making decisions,” Liersch says. “This can keep you from feeling overwhelmed during volatile markets.” On the other hand, if you’re not the person who manages the money, Liersch suggests reaching out now. “You don’t want to look back and be upset you weren’t engaged. Plus, you help take the burden off your partner.”

If you don’t have a partner, Liersch recommends finding someone else you trust, like an adult child, a sibling, or a financial advisor. “People in retirement tend to trust those outside of whom they should trust because they don’t want to burden their loved ones. That isn’t the right approach. Don’t go it alone and get the people involved who will be impacted by your investments.”

Watch out for herd mentality

While Liersch recommends having one collaboration partner, he also warns not to rely on everyone you know for advice. “It’s ok to have conversations, but ultimately you need to make decisions based on your own personal situation. Don’t try to match the retirement lifestyle and investment strategies of others, especially if you don’t know all the details of their financial plan.”

Keep market conditions in perspective

This has been an unusual year, between soaring inflation, a bear market, the lingering impact of COVID-19 and supply shortages. Yet this is far from the first time investors have faced unusual conditions. “I hear a lot that this is unique and we have never faced a time like this in history,” Liersch says. “But if you look back at headlines from the 1980s, ‘90s, 2000s, there were other periods of high stress with a level of uniqueness.” 

Liersch notes that people tend to spend less time on their investment decisions and depart from their financial plans when they assume the old rules no longer apply. “Don’t fall into this trap,” he says. “Stick with your plan and remember there have always been market cycles. It will give you the strength to get out of this one.”

 

This article was written by David Rodeck from Kiplinger and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to legal@industrydive.com.