What To Do When Markets Plummet – Investor Behavior Gap

Another
concern is whether investors are disciplined enough to stay the course with the
investment strategy in order to earn the underlying index market returns.
Studies on retirement spending from investment portfolios typically assume that
retirees are rational investors who rebalance right on schedule each year to
their rather aggressive stock allocations. They never panic and sell their
stocks after a market downturn. For many retirees, this may not describe their
reality. The behavior gap refers to the concept that investor behavior may
cause real individuals to underperform relative to index market returns.

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The behavior gap has been estimated, and there is somewhat of a consensus,
that individual investors do underperform the overall markets by a couple
percentage points per year. For instance, Vanguard’s study of Advisor’s Alpha
identifies the most important factor explaining investor underperformance as a
lack of behavioral coaching to help investors stay the course and stick with
their plans. They estimate that having the wherewithal to stay the course in
times of market stress could add 1.5 percent of additional annualized returns
to the portfolios of typical investors. In other words, without behavioral
coaching, the typical investor could expect to underperform the markets by 1.5
percent per year due to poor decision-making.

Evolution has designed us not to be effective long-term investors, but
rather to seek to avoid short-term dangers. The fields of behavioral finance
and behavioral economics have uncovered various biases humans have that are
helpful for day-to-day survival, but somewhat maladaptive for long-term
investing. A significant body of research is dedicated to detailing these
investor behaviors. These are some of the most common behaviors that lead to
poor financial outcomes.

Availability Bias/Recency Effect: Using recent or current market behavior
to predict future market behavior

The most recent events are always freshest in our minds, and we tend to
extrapolate recent events into the future, expecting more of the same. We tend
to make long-term decisions based on short-term performance. Large recent
market gains lead us to be optimistic about our chances, while market losses
have the opposite effect. It takes discipline to overcome these natural
tendencies to simplify matters into what can most easily be recalled.

Loss Aversion: Fearing a loss more than you want to make gains

As human beings, we tend to feel that the pain of experiencing a loss is
greater than the joy felt by an equivalent gain. This leads to emotional
decision-making for financial decisions, as we feel worse about losing relative
to a starting point than a symmetric gain from the same starting point. With
evolution, this was probably a useful survival tool, but it does not help with
investing. It can lead to the avoidance of stocks that require accepting
greater short-term volatility (and paper losses) in the effort to achieve
upside growth potential and long-term gains. Not recognizing this
predisposition can cause people to misjudge their tolerance for risk, making
them more likely to bail on their financial plan.

Overconfidence: Believing
you know more than other investors

While investment research increasingly points to the difficulty of beating
the market—especially after fees, trading costs, and taxes are taken into
account—it is natural to believe we know more than everyone else. This is the
“Lake Wobegon effect” in practice. As Garrison Keillor relates in A Prairie
Home Companion,
Lake Wobegon is a place “where all the children are above
average.” It is all too easy for investors to fall into this kind of thinking.
We tend to be too confident in our decision-making around random and uncertain
events. This may lead to too much trading and less-than-prudent amounts of
diversification.

Hindsight Bias: Thinking you
can predict market behavior because you believe you know why past market
behavior occurred

In hindsight, market losses may seem to have an obvious or intuitive
explanation. We seek to construct a narrative with cause and coherence, such
that memories about past events suddenly become straightforward and
predictable. This bias can feed into our overconfidence and cause us to believe
we will be able to anticipate such market changes the next time around.

Survivorship Bias:
Underestimating the risk by ignoring the failed companies

We may underestimate the degree of market risk if we look only at companies
still operating today. This misses out on the lessons of many failed companies
no longer on the investment radar. It is like thinking a marathon would be easy
to run because you watched a bunch of people cross the finish line. You’re
ignoring all the people who gave up before reaching the end. This can also feed
overconfidence.

Herd Mentality: Judging your
own success or failure based on that of others

Sometimes the herd mentality can be rationalized. You don’t want to miss
out on being rich when everyone else is rich, and perhaps being poor is not so
bad when everyone else is also poor. But for a long-term investor, following
the herd rarely makes sense. It leads to joining the same greed and fear cycle
that drives the average investor to buy after markets have already gained and
to sell after markets have already dropped.

Ambiguity Aversion:
Disliking uncertainty leads to betting on what is known

This behavior drives investors to bet more on what they know than on what
they do not know. It has been offered as an explanation for the equity premium
puzzle. Stocks have outperformed bonds consistently and by relatively wide
margins over time, more so than can be explained by their risks for long-term
investors. It may be because investors prefer the short-term safety of bonds,
not recognizing the greater long-term growth potential of stocks.

Framing: Reacting
differently based on whether the same outcome is presented as a loss or a gain

People’s decisions can also be based on how a problem is framed, even if
the underlying problem is the same. For instance, asking someone the
probability they will live to eighty-five should lead to an answer that is 100
percent less than the probability that they will die by age eighty-five. But
framing the problem in terms of dying by eighty-five leads to much less
optimism than framing the problem as surviving to eighty-five.

Home Bias and Company Stock:
Preferring what is most familiar

Our brains are more comfortable with the familiar. At the extreme, this can
lead to disproportionate ownership in one’s own company stock, or more simply a
bias toward domestic assets over international assets. Both actions lead to a
less diversified portfolio and greater exposure to risks that could have been
diversified away.

Behavioral Cycle of
Investing: Buying high and selling low

Falling markets can be stress-inducing events as we witness our wealth
evaporating at a quick pace. This stress can trigger short-term fight-or-flight
mechanisms in our behavior that may have helped to avoid day-to-day dangers on
an evolutionary basis, but which are not adapted toward sustaining long-term
investment success. Market volatility can lead to bad decision-making and to
jettisoning well-considered plans. Short-term stress reactions will often
involve deviating from the financial plan and selling stocks out of fears for
further portfolio losses when historical evidence overwhelmingly suggests it to
be wise to stay the course with the plan to build greater long-term wealth.
Once a well thought out investment plan is in place, it is frequently better to
do nothing in the face of stressful market situations. But this counters human
evolution about the way to respond to such situations.

In times of market stress, it is important for retirees to stick with their
financial plans and the asset allocation that matches their tolerance for
market volatility. Most research about retirement spending from an investment
portfolio assumes that investors behave in this rational way. Unfortunately,
investors in financial markets tend to do the opposite of what happens in most
other markets: they buy more when prices are high and sell when prices are low.
This causes returns to drag behind what a “buy, hold, and rebalance” investor
could have earned. To the extent that households fall victim to bad behaviors,
the net returns and sustainable spending rates from their investments will be
less than otherwise possible.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

 


Originally posted at https://retirementresearcher.com/what-to-do-when-markets-plummet-investor-behavior-gap/

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