By Sarah Max
Dec. 11, 2020
Investors have been challenged like never before in 2020 as the pandemic took the market from the record highs that marked the start of the year, to the brink of a depression by the end of March, and back to record highs.
And if daily headlines about Covid-19 and its economic impact weren't enough, many investors are grappling with conflicting emotions: boredom and anxiety, hope and fear, gratitude and guilt. These emotions can be particularly debilitating to retirement savers, whose decisions today can have a lasting impact on their ability to amass enough for a decadeslong retirement.
It can be difficult to make sound, emotion-free investment decisions in even the most typical of times, but the environment today could be a case study in bad behavior. "We are just constantly stressed in a way that we're not used to, and in an environment that is so uncertain and ambiguous," says Maria Konnikova, an author with Ph.D. in psychology who specializes in decision making.
Yet as the stock market's round trip has shown, the biggest influence on our retirement savings might not be what we hear on the news or read on social media. It's how we respond to it.
And how have we responded?
When markets tanked in March, many investors did exactly what they were supposed to do—stayed the course and in many cases increased their retirement contributions. Still, a large share of investors cashed out or remained on the sidelines, fearing that the worst was yet to come—and who can blame them? Losing money, especially if you’re counting on this cash to cover near-term expenses, is perhaps more painful than missing out on market gains.
Investors generally grapple with two elements of decision making: the impact of the decision and the emotion that comes with it. "Fear of future regret probably drives more behavior than anything," says Denise Shull, a former trader and CEO of the ReThink Group, a decision-making and performance consultancy.
It’s impossible to know what the future holds, but there are strategies for avoiding the biggest behavioral mistakes. In fact, by focusing more on the process for making decisions and less on whether a decision is “good” or “bad,” you have a better chance for success—and a lower probability of driving yourself crazy.
Mistake: Trying to Game the Market
The Covid-19 pandemic has given rise to all kinds of new habits and behaviors, and that includes what Charles Schwab chief investment strategist Liz Ann Sonders calls a "new breed of day trader." With new apps such as Robinhood and Webull at their disposal, investors of all ages have taken to trading individual stocks and even options.
Daily trading volume driven by individual investors has averaged 20% this year—double what it was in 2019—and approached 25% on peak days, according to Citadel Securities. Meanwhile, options premiums paid by individuals reached an all-time high in August, and after declining in late October, they are up again. “There is more volume in single-share options than there is in the actual shares themselves,” Sonders says.
Is it any wonder that many investors have a newfound interest in the stock market? Rising stocks can offer a nice dopamine hit in the absence of good news—and the market has continued to reach new highs as the news has been largely bleak.
“I’ve never had so many friends and family members so interested in investing,” says Sarah Newcomb, a behavioral economist for Morningstar. She points to a combination of factors: many people have more time on their hands—and more money in their pockets. Trading stocks was among the more common uses for the $1,200 stimulus cash, according to Envestnet Yodlee, a software and data-aggregation company.
"It's a perfect storm for DIY investors," Newcomb says.
In fact, one of the unusual things about the Covid-19 market is that while the selloff was fast and extreme, so was the recovery. "We have seen an entire market cycle condensed into an incredibly short span of time," says Sonders, explaining that investor sentiment is affected by both the severity and the duration of bear markets. "This helps explain the lack of pervasive despair that investors typically have in a deep bear market."
The payoff for staying invested came quickly, and for investors who stayed put or bought on the dips, the market’s return reinforced their beliefs. “I think people’s recollections of 2000 and 2009—how in hindsight it was a good time to stay invested or enter the market—did play a role in turning the market around,” says George Lowenstein, a professor of economics and psychology at Carnegie Mellon University. “Now it seems to be fueling itself.”
Confirmation bias, or the tendency for people to hear what they want to hear, is running rampant. "There seems to be an asymmetric reaction to news," says Lowenstein, explaining that any bit of good news sends the market higher, while bad news seems to have little impact.
Advice: The conventional wisdom from most experts on trading individual stocks or options is simple: Don’t do it. While options can be a tool for managing risk, speculating with options can be risky and costly. If you must buy individual stocks, wager only with money you’re prepared to lose—and that means money you might have otherwise spent on travel or other entertainment, not retirement.
Set a budget for buying individual stocks and create a dedicated account. Next, write out your investment process—for example, your logic for buying—and your exit strategy on when to take profits on winners or unload losers. “You need to articulate exactly why you are buying a stock and under what parameters you will get out,” ReThink’s Shull says.
A key part of the process, she adds, is deciding which experts to follow. "There's so much information out there, much of it conflicting," she says. Identify a few smart sources that resonate with you, she says, and tune out the others.
Mistake: Hoarding Too Much Cash
Investors who stayed invested or upped the ante on equities have, in many cases, been rewarded. But now investors need to make sense of a market that seems at odds with the current economic reality. This was what prompted some investors to cash out during the March selloff and never get back in, or put their contributions on hold while they wait for a signal that the coast is clear or confirmation that they made the right decisions.
"People look at the apparent disconnect and it becomes a reason to justify not being in the market," says Jurrien Timmer, Fidelity's director of global macro.
Fear is obviously a big driver, and understandably. Investors shouldn't discount fear, says Shull, but neither should they blindly trust it. Instead, she recommends going through the exercise of "what's the worst that can happen." Not only can this help identify blind spots in a plan or important precautions to take, it can also help investors take more appropriate amounts of risk.
"People often go straight to the worst possible outcome, but if they really think through it logically they realize that the worst case isn't that bad, and it changes their willingness to tolerate the feeling of risk," Shull says. "So much of that is tolerating your feelings; separating valid information from the irrelevant impulses."
Advice: Chris Zaccarelli, chief investment officer at Independent Advisor Alliance, says one way to address this fear is to do an analysis of what a sustained downturn would do to your portfolio, and how that affects your retirement timeline or income. In many cases, weathering the downturn is better than missing out on long-term gains.
"It can help investors feel more comfortable with risk," he says. "They understand that even under some of the worst scenarios, their nest egg will be protected and they can make it through."
For investors who are still anxiety-ridden, Ric Edelman, founder of Edelman Financial Engines, has a few suggestions. First, his firm is counseling clients of all ages to increase their emergency savings to cover up to two years of living expenses so they don't have to worry about selling assets in a down market.
The next move is to consider reducing equity exposure, he says. Going from a 60% stock allocation to 50%, for example, will be less detrimental than cashing out entirely.
For clients who can't stomach any exposure to stocks right now, he offers this compromise: Go to cash but with a concrete plan to dollar-cost-average back into the market within a predetermined period of time, such as six months to a year.
Mistake: Reshuffling Your Portfolio
This might be the most common mistake investors make—and unlike speculating on individual stocks or sitting on too much cash, it’s a mistake that is a little harder to pin down.
When the market was at its most volatile earlier this year, "investors did not run for the hills but they were making changes to their accounts," says Cory Clark, chief marketing officer of Dalbar, which found that nearly a third of investors working with traditional or robo-advisors reallocated their assets during the Covid market crisis.
Notably, they shifted from passive funds to more active strategies. They also shifted between sectors, such as by increasing exposure to technology and precious metals. The decisions seem rational at first glance, but did they work? "We saw a lot of bouncing around but didn't see greater alpha," Clark says, referring to Wall Street parlance for excess returns.
During times of uncertainty, making changes in a portfolio offers a "sense that you are actually able to make decisions about risk that you can't make in your daily life anymore," says Dan Egan, managing director of behavioral finance and investing at robo-advisor Betterment. "One of the things we know is that people hate doing nothing when they are in an anxiety-provoking situation."
It might feel good in the moment, but the data show that over time the odds are stacked against investors who try to time the top or the bottom or rotations in styles or sectors. Myriad studies have shown that
Take heart. Even professionals grapple with this. "The quintessential challenge is how can you be fully engaged but detached," says Fidelity's Timmer, who points out that markets are in a 10% correction about 50% of the time. "You have to do what you can to keep that separation or balance. I go on very long bike rides. I try not to overread short-term market commentary. I barely watch news on television, even though I'm on the shows."
Advice: It’s an old saw, but this is why having a plan is critical, the experts say. A plan can also help to articulate all of the factors behind your decisions. Professional investors refer to this as their process—ground rules for why and when they buy or sell a security.
"The best way to prevent your emotions from dictating your behavior is to establish a rules-based strategy," says Edelman, who adds that these issues are compounded when spouses have opposing views. "While you're calm and contemplative, you can establish a set of guidelines that you agree to follow."
The upshot: You can't control everything that is going on in the world, but you can control your process for making decisions. "Your focus has to be on process," says Konnikova, the psychologist and decision-making expert, "because that's the only thing you can control."
Copyright 2020 Dow Jones & Company, Inc. All Rights Reserved.