Market Stress: How Emotions Can Hurt and Help Your Portfolio

Key Points

  • As investors, we are human—and humans have behavioral and emotional biases that can make investing challenging, a growing body of economic research shows.
  • Market shocks and volatility can trigger behavioral responses—and the responses can be amplified if you’re in or near retirement.
  • We discuss three key behavioral tendencies and solutions to help.

Think about the last time the market experienced shock. Were you tempted to join the crowd rushing for the exits? For example, did the U.K.'s recent "Brexit" vote to leave the European Union make you nervous enough to start thinking about selling some of your investments even as the market was falling?

Emotional reactions to shocking events are all too human, of course. But giving your emotions free rein over your investment decisions can be risky. The same is true of other cognitive biases that are a common part of human experience.

This isn't to say we need to constantly struggle against our less-rational reactions when it comes to investing. Rather, it makes sense to be aware of them and, if possible, to redirect them to work in our favor.

How can emotional biases work to your advantage? Here are three problems in behavioral finance and two solutions to turn them in your favor.

Problem #1: Loss aversion

We tend to feel the pain of a loss more than we enjoy the pleasure of a gain. This behavioral finance concept, known as loss aversion, is backed by ample research and may not be a surprise to many investors. A falling market tends to grab our attention more than a rising one.

Loss aversion may be particularly keen for retirees. After all, investors face real, magnified risks when they are nearing or in the early days of retirement. This is known as sequence-of-returns risk. It refers to the lasting damage that can be done to a portfolio if an investor sells retirement assets in a falling market early in retirement. Selling assets at depressed prices can mean selling more of them to raise a set amount of cash. And burning through too many assets in the early stages of retirement can deprive a portfolio of resources it needs to bounce back if the market starts rising again.

But loss aversion can also go too far. For example, it can keep us from harvesting gains from investments designed to grow, or selling any assets at all. Some retirees try to live only off the income their portfolios generate, without ever selling any of their assets. Selling an investment, or using cash set aside for spending, is perceived as a loss.

Loss aversion is normal. We wouldn’t be human if we didn’t have it. But generating income in retirement is about more than just interest payments or dividends. It can also mean strategically selling investments as needed.

Problem #2: Anchoring

Anchoring is when you seize on an initial estimate about how much something might cost and then continue to use that number as your basis of comparison, even if it's not actually relevant. For example, imagine a friend tells you he heard that a house had gone on the market for $500,000. You ask the seller and he says he's selling it for $400,000. That sounds like a bargain, so you put in an offer. But is the bargain real? Or only in comparison to that initial price estimate? Later, you find out the market value of the house is actually $300,000. "Anchoring" to the rumored $500,000 price tag led you to offer too much.

Here's an example from the investing world. You may have heard that stock markets have historically returned an average of 12% a year. That sounds pretty appealing, but it would be a mistake to use that as a benchmark for your returns in any given year. First of all, it's highly unlikely returns will match a long-term average in any given year. They are more likely to be higher or lower. Second, that's not a realistic figure for a portfolio without greater risk, given the current low interest rates and high valuations in the stock market, in our view. Schwab’s current expectation of stock market returns is just under 8% per year, on average.1

For bonds and other less-volatile investments, we might look for 4% as a benchmark for yields, remembering returns available in prior markets. But this likely isn’t realistic in today’s financial markets. This doesn’t mean you can't find investments with 4% yields. But a 4% yield—or any other yield much higher than the rate on short-term investments or cash—comes with risk.

Each of us has to figure out how much return we aim for over time for taking a comfortable amount of risk. However, there is no such thing today as a no-risk 4%-yielding portfolio.

Problem #3: Recency bias

Recency bias refers to a focus on a recent event to the exclusion of the context of the past. The biggest change in financial markets over the last 30 years has been the amount of information available—on all topics, not just investing—and the speed with which we receive it. News is also repeated, over and over, so that negative events, however unlikely they may actually be, come to seem common, even expected.

This doesn’t mean negative events aren’t important. Thinking about and preparing for the unexpected is something many of us do in our daily lives. Have a plan for managing unexpected short-term troubles helps us focus less on current events, and more on long-term plans.

The news is right in front of us. The future is in the future. We need strategies to separate the two, to enjoy life—and retirement. Here are two approaches to dealing with our unruly cognitive biases.

Solution #1: Mental accounting

Mental accounting is the tendency to think about one dollar differently from another dollar, depending on where it came from. For example, some people find it much easier to spend a windfall, like an unexpected bonus, than they do money from their savings account. Mental accounting can also be  helpful when it comes to balancing the risk of short-term losses with need for long-term gains when you have different goals or time horizons.

With an investment portfolio, it can be tempting to treat it as a single thing—and then fixate on a single number. How much did it rise or fall? But that kind of focus could actually heighten our anxiety in moments of crisis.

That’s where mental accounting comes in. Dividing your money into different "buckets" and then devising an investment strategy for each can help when it comes to planning for essential and short-term needs versus non-essential or longer-term needs. Once your investments are divided in buckets, you can take a more nuanced look based on the goal of each bucket. Look at your lower-risk investments. How much did they move after a crisis? Compare them with the higher-risk, longer-term investments in your portfolio. How much did they move?

Volatility isn’t pleasant, but if you know you have a bucket of less-volatile investments to cover your essentials in the near term, volatility in other investments may be easier to handle emotionally. Consider bucketing investments by essentiality and time horizon. For retirees, or those getting close, we suggest a simple bucket approach.

If you don’t have your baseline covered, panic is a natural response. If this is how you respond to market stress, your investments may not be "bucketed" for your needs, time horizon or risk tolerance.

Solution #2: Write down your plan

Writing down key principles and rules in advance of future events—especially if you vet and discuss them with a trusted advisor—can help shore up your discipline in times of stress.

As you create your investment policy, consider some of the following tips on how to put mental accounting to work in your favor:

  • Ask yourself what money you’ll need in the next two to four years. You could bucket that money in lower-risk investments including cash, short-term bonds and other lower-volatility investments.
  • Aim to build up predictable income streams from a diversified portfolio of bonds and stocks that you don’t feel you’ll need to sell in a bear market.
  • Consider annuities and other guaranteed sources of income to help protect your baseline income. Such investments can make it emotionally easier to take risks for higher returns, over time, with the rest of your portfolio.
  • Ask yourself what money you’ll need in four years and beyond. Bucket that money in investments with an appropriate level of risk for your time horizon—and avoid making sharp, immediate changes to these assets in times of stress.
  • Finally, talk with an advisor about an appropriate spending rate from your portfolio, based on a financial plan or your personal spending rate, in addition to interest rates or yield.
  • After considering these objectives, it can help to write down your basic investment policy, including an asset allocation and mix of investments that matches your time horizons and goals.

What to do now

Consider the points above and ask:

1. Do I have my buckets positioned so that I can balance short-term risk with a long-term investment strategy?
2. Do I have an appropriate investment policy for each bucket, along with a sense of how much I can spend, that isn’t tied to interest rates or short-term market performance?

Each of the strategies can redirect emotions to work in your favor, rather than against you.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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