3 Mistakes to Avoid in Volatile Markets
Filbrandt Reports
Volume 20, Issue 7
Report Summary:
In this Market Update, you will learn:
- How recent volatility compares with the past market corrections
- The future impacts of rebalancing a portfolio during down markets
- How bonds are performing in the current environment
- When you should consider buying stocks
What a crazy few months we have been through! The broad stock market declined more than 30% from its February highs, only to rebound more than 40%. And that’s just referencing the stock market. Volatility seems to bring out the worst in investors, as behavioral errors systematically separate individuals from their money. This article will revisit some of these errors while they are still fresh in our minds.
Historically, the investment performance of the average investor woefully underperforms that of broad market indices. In a study covering 30 years, equity fund investors garnered less than half of the returns of the stock market, while bond fund investors achieved about 1/12th the gains of the most common bond index (see chart below). Compounded over time, the results are disastrous for investors’ financial health. Avoiding the three mistakes listed in this article will help your financial plans stay on track.
Mistake #1 - Assuming we know more than the markets.
One should assume that the market has priced in all publicly available information, and even some non-public information (i.e. insider trading). Hubris is not a friend of investors. A 1998 study by De Bondt* concluded people who consider themselves experts, in any field, often overestimate their abilities and incorrectly attribute past successes to their skills. Thinking that the market is not aware of the information we have is a costly mistake. In fact, the view of an expert can be myopic and does not consider factors outside of their field of knowledge. Being an “expert” seems to provide a false sense of knowing what will happen. And as we have seen, not all data can be trusted.
Mistake #2 - Allowing our emotions to drive investment decisions.
Emotions are fleeting, yet powerful creatures that can overpower our thinking during times of stress. The pain of losing is about twice as strong as the pleasure of gaining, according to Schindler and Pfattheicher**. Short-term, loss-aversion behaviors can result in long-term damage to investment plans. Portfolios are built knowing that markets will go up and down, sometimes wildly. Because of this, managing our emotions is perhaps more important than managing our investments. A properly diversified portfolio will do just fine if we don’t touch it, but our emotions sometimes insist that we tinker. This tinkering rarely provides any value.
Mistake #3 - Believing a market drop is a precursor to further market declines.
Our minds extrapolate recent trends. During a rising market, we begin counting future gains. After a sudden drop, doomsday scenarios emerge in our heads. A 2014 study by Bucher-Koenen and Ziegelmeyer*** looked back at the 2008 financial crisis and found that even after the stock market had declined by 40%, investors assumed prices would continue lower. Since future stock market returns are largely predicated on the price that we pay today, a drop in the stock market increases expected long-term returns. A methodical practice of rebalancing, like the one used at Filbrandt, can help avoid this pitfall.
Finally, a financial plan is only as good as the execution. The three mistakes mentioned here, which are all forms of “market timing,” can wreak havoc on your retirement plans. Hiring an investment manager with disciplined money management practices, as well as effective client communication skills, can ensure that your financial health remains intact during volatile markets.
*De Bondt, Werner F. M. (1998). "A Portrait of the Individual Investor," European Economic Review. Elsevier, vol. 42(3-5), pages 831-844, May.
**Schindler, S., & Pfattheicher, S. (2017). “The Frame of the Game: Loss-framing Increases Dishonest Behavior,” Journal of Experimental Social Psychology, 69, 172-177
***Bucher-Koenen, Tabea and Ziegelmeyer, Michael Heinrich, (November 19, 2013). “Once Burned, Twice Shy? Financial Literacy and Wealth Losses During the Financial Crisis,” Review of Finance, 2014, vol. 18, issue 6, 2215-2246
Related Articles
- To learn more about portfolio management during a crisis, read this report: 3 Critical Steps to Weather An Economic Storm
- To learn the benefits of maximizing tax efficiencies in an investment portfolio, read this report: Don't "Beat the Market," Maximize Your Bottom Line
Have a Question?
As part of our commitment to promoting financial literacy among university professionals, you can schedule a 15-minute phone call with an expert at Filbrandt & Company to learn how these important topics apply to your own situation.
