The Psychology of Fear: How Loss Aversion Impacts Investor Behavior

I take far more calls when the markets are down than up. Investors are more fearful during a drop than they are optimistic during a climb. Positive returns feel good but negative returns are outright painful.

One can attribute these unequal feelings to the loss aversion bias, a human tendency impacting investment returns from the beginning. 

What is loss aversion bias?

Kahneman and Tversky’s well-known phrase “losses loom larger than gains” sums it up. The basic principle is that feelings from losses are more powerful than pleasures from equal gains. Some studies hypothesize the negative feelings are almost twice as strong. This phenomenon discourages risk-taking even when other data would imply an attractive risk-reward ratio. 

How does it impact investor behavior?

It’s often said that time in the market is more important than timing the market, but the loss aversion bias may be the force behind many ill-timed market exits. 

Market corrections are normal. I often describe volatility as the price of admission. In fact, according to Fidelity, the S&P 500 Index has, on average, recorded a 5% pullback three times a year, a 10% correction once every 16 months, and a 20% plunge every seven years. When the market moves up smoothly, it’s unnoticed by many, but when it pulls back, many investors reach for the panic button. It may feel good to get your money out of harm's way, but you are likely missing out on future returns as a result.

Timing the market is difficult!

It sounds easy, but in reality, it's difficult to time the market successfully. According to First Trust, from 1926 to 2019, the average bull market lasted 6.6 years and cumulatively returned 334%. The average bear market, in comparison, lasted 1.3 years with a cumulative loss of 38%. 

To successfully time the market, you actually have to make several well-timed decisions in a short period of time.

First, you must exit the market at or near the top. If you exit prematurely, you‘ll be caught on the sidelines and miss out on gains.

Then, you must re-enter the market towards the bottom. Correctly executing either one of these is a tough feat, but doing both is an immense challenge. Botching the exit or re-entry can wipe out any benefit or even result in a worse outcome than maintaining a disciplined long-term strategy. 

Consider this:

Let’s say you actually did ok and captured some benefit with your timing activities. Were those trades executed in a taxable account? If so, did you consider the tax implications? If you only saw a modest benefit, it could be negated by taxes owed. Did you pay commissions, fees, or other transaction costs? If so, did you consider how they impacted the success or failure of your timing strategy? It’s important to see the entire picture before determining the strategy a success or failure. 

Being disciplined isn’t easy.

It’s tough to stay on course. This is true of maintaining a healthy lifestyle, following through on personal goals, and investing in the future. It’s easy to slip up and make rash decisions, especially when human nature intrudes. I find Jeremy Siegel’s quote to ring true “Fear incites human action far more urgently than does the impressive weight of historical evidence.”

That’s what a financial advisor is for, to help you keep perspective when fear, uncertainty, and doubt creep in. Managing human behavior is an essential part of my job and impacts financial outcomes like portfolio construction, asset allocation, and other essential advisor responsibilities. 

If you don’t have a strategy, you should consider working with a professional to create one that reflects your objective, time-horizon, and risk tolerance. Without a strategy, you might be more tempted to flee for the exit at the wrong time. 

When the markets drop, use history as a reminder that it’s totally normal. If you have extra cash, it could be a good time to deploy (if that’s consistent with your strategy). And when emotions run high, contact your advisor. A healthy advisor-client relationship is a two-way street, and that communication will strengthen your advisor's understanding of your situation and mindset and help them better serve you. 

***This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from James Vermillion, and all rights are reserved.**