From Cambridge Associates:
Like all animals exposed to danger, human beings are hard-wired with “fight or flight” survival instincts. But our innate risk aversion can be problematic when it comes to investment decision-making during a market downturn.
Investor risk tolerance is not static, but instead shifts with asset prices. Paradoxically, human instinct gives investors the impression that risks are rising when markets are falling, which can prompt them to cut exposure precisely when the risk/reward proposition is often moving in their favour.
Conversely, a prolonged bull market such as we have experienced can lull investors into a false sense of security, when, in fact, financial asset prices are vulnerable to correction. As a result, executing a rebalancing policy during a sustained market correction requires investors to boost exposure to risky assets in the face of rising fear. Easier said than done!
Behavioural economists have identified, analysed and documented dozens of behavioural biases, many of which can negatively influence investment decisions. Long-term investors facing a downturn are most susceptible to loss aversion, herding, recency bias and availability bias. When downside volatility picks up, so does loss aversion. Investors often lose sight of the strategic investment objective and instead become preoccupied with the “nominals” as mark-to-market portfolio losses mount, preferring the safety of the herd. The goal swiftly becomes to stem the bleeding, at any cost.
Investors also tend to exaggerate the importance of recent information and to forget the longer-term historical context during times of market stress. As market uncertainty rises, investors can lose their objectivity and begin grasping onto any available information and advice, regardless of its strategic relevance and particularly if the source is perceived as a market expert.
Experienced in combination, and without effective strategies to mitigate them, these natural human reactions to short-term financial pain and loss can be devastating to the long-term investment mission.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.