Investor panic was a culprit in the market nosedive that left major exchanges down more than 20 percent by the end of the month. The emotional reaction to Black Monday triggered investors to sell in a panicked state rather than follow a strategic plan.
What have we learned in the almost two-and-a-half decades since Black Monday? Some investors, it seems, have learned very little—recent events show investors still follow emotions rather than creating a plan based on goals. Here are some things to keep in mind:
The recency bias. The investing public is reactionary. Investors show classic symptoms of recency bias—the tendency to place too much importance on something that just happened rather than looking at long-term expectations and the bigger picture. Recent events are freshest in the mind, but they aren’t more important simply because they just happened.
Loss aversion. Investors who’ve lost money in the past, maybe during the ’87 crash, could have a more pronounced reaction to a downturn. In behavioral finance, that’s called loss aversion. The theory states that people dislike losing money twice as much as they like making it. Accordingly, when someone has experienced a loss, lingering emotions influence judgments. An investor’s overall confidence level can be diminished, and the instinct to cut and run kicks in.
Herd mentality. When investors lack confidence in investing decisions, they may make choices based on the rest of the pack. They hear there’s a sell-off on one of the major exchanges—so they sell. It doesn’t matter whether their investments are included in that exchange, or even if selling fits with their goals.
When we mash the fear that stems from the recency bias and loss aversion with a herd mentality, we have a recipe for bad investing decisions. So if it’s human nature to react emotionally, what’s a person to do?
The solution isn’t simple. It involves some up-front work and a lot of will power. Many average investors won’t make the time to do the work necessary to retreat from the emotional investing cycle. It can be done though—everyone can do it.
First, decide on a goal. Picture the goal in your mind. (Maybe it’s traveling to China, funding your children’s education, building your dream home, retiring to Arizona, or spending more time with your family.) Make it your mantra, daily affirmation, or hero’s call—whatever you need to do to keep focused on the goal.
Next, create a strategy to reach your goal. This is the part that will require some work. Use online calculators to determine saving amounts, analysis tools to determine risk preference, and asset allocation tools to help with investment selection. There’s plenty available online to get you on your way; or you could seek the help of a professional. Just be sure your adviser understands your goals and isn’t just trying to sell you on an investment product.
Finally—and this is the hard part—initiate your strategy and stick to it. Don’t make changes because of a headline or something you heard from a co-worker. Don’t make a change based on herd mentality or fear. Remember your original goal and stick to your plan.
The anniversary of the ’87 crash should give us time to think about our investing actions, or reactions as it were. If you’ve made your investing decisions based on your emotions in the past, this is a great time to get those feelings in check and move forward.
Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal. Keep tabs on Scott on Twitter and Facebook.