After headlines noting “the biggest daily stock market drop in oil prices since the Gulf War” and “the S&P 500 ETF’s third-worst opening in history,” it’s only natural for investors to fear what comes next. And given how our minds judge probability and forecast the future, it’s understandable to want to pull out of funds.
It can be easier to successfully navigate moments like this if you understand the particular causes of investors’ financial anxiety. Instead of asking yourself if a client is doing the right thing, it’s more fruitful to ask, “Why do they want to do this?”
How market volatility impacts investor behavior
Reactions to market volatility can be attributed to a couple of behavioral phenomena.
1. Our minds use the recent and vivid past as a guide. We’re all hard-wired to see things that readily come to mind as indicative of the future. For example, research from Amos Tvserky and Daniel Kahneman showed that the most vivid and recent things—like a drop in the stock market—are far more compelling than events in the distant past.
On a fundamental level, this applies to everyday life. If we see a car coming straight at us, we don’t recite to ourselves, “Past performance doesn’t predict future performance. Therefore, the car is going to swerve. I’m safe.” No, we take the recent and vivid past as a guide for what’s going to happen next. In investing, that’s sometimes referred to as recency bias. Our first instinct isn’t to think about how markets recovered from the crash of 1987 or the dot com bust—it’s to think about what has been lost within the last couple weeks.
2. We watch how others respond. There is another cognitive bias in which we tend to follow others when we aren’t sure what do to (for example, this was explored in Jessica Nolan’s paper “Normative Social Influence is Underdetected”). It’s hard to go against social norms, and we fear rejection if we do.
In everyday life, when we don’t have good information of our own, it can be quite reasonable to follow the group. But when it comes to investing, these biases can lead us astray. Assuming that short-term market volatility is going to lead to a long-term, permanent loss of capital isn’t useful. In fact, it’s often the opposite. And in investing, if the herd is acting according to that belief, there may actually be better opportunity for investors in another direction.
Recency bias and herding behavior are egged on by the headlines and social-media doom that accompanies market volatility, making them feel more real and immediate than a carefully considered, long-term plan from years ago.
As an advisor, you can have a calm, rational discussion with a client experiencing financial anxiety about how the market instability is probably going to be overblown. But if the client’s neighbor is screaming about how we’re headed for another recession, that overrides everything else.
How advisors can address financial anxiety
Vividness is often one of the reasons that we get anxious about market volatility. The more vivid a downturn is, the more real it feels.
So, you can fight vivid with vivid. Offer a vivid example of other investors who gave in to herding behavior during the market downturns of the SARS scare or Zika outbreak and ended up losing out on substantial gains in the aftermath. The intent isn’t to scare people, but to make the outcomes clear and powerful.
Then give a vivid, real, personable example about the people who stuck to their long-term plans through one of these scares and ultimately thrived. The abstract is useless. It’s about how well you can help a client visualize the person who had the right approach to handling market volatility.
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