When markets experience volatility, even the most level-headed investor can let their emotions or other influences affect their decisions. Read on to find out why volatility can trigger financial biases and how these might affect you.
For the average investor, it’s important to take a long-term approach. While returns cannot be guaranteed, investing over a longer time frame gives markets more time to smooth out their natural peaks and troughs.
Headlines about market crashes or sudden rallies can set you on edge even if you’re usually calm.
Volatility affects investors because uncertainty triggers an emotional response. When you’re thinking logically, you might note that markets have historically recovered from downturns. However, it’s easy for worries to creep in. You might ask yourself: “What if the market doesn’t recover this time?”
As investments are typically tied to personal goals, these initial worries can spiral, allowing emotions to drive your decisions.
4 types of bias that could affect your investment decisions during volatility
1. Herd mentality
When there’s uncertainty in the market, it’s natural to look at what other people are doing. It can often seem like everyone else is taking the same approach. This can lead to a bias known as “herd mentality”, where you’re tempted to follow the crowd.
It might feel like there’s safety in numbers, but it’s important to avoid making decisions that aren’t right for you just because others are doing the same.
2. Loss aversion
No one wants to see the value of their investments fall, and psychological research suggests that investors fear losses more than they enjoy gains. So, to avoid or reduce losses, investors might sell because they’re worried markets will fall further.
However, this may lead to investors turning paper losses into actual ones. In contrast, sticking to your long-term plan and being patient could mean you benefit from a market recovery.
3. Recency bias
The theory behind recency bias argues that investors place too much emphasis on recent events. So, you might decide that a dip in the market is actually part of a long-term trend, even if the data suggests otherwise.
Taking a step back to look at the bigger picture could help you keep recency bias in check.
4. Confirmation bias
Confirmation bias refers to the tendency of investors to seek out information that supports their existing views.
If you’re worried about markets falling, confirmation bias can lead you to dismiss positive data in favour of negative information. This bias can intensify your fears and lead you to make decisions based on only a small portion of the available data.
Practical ways to reduce the effect biases have on your investment decisions
Emotions and bias interfering with your logical decision-making is normal, but that doesn’t mean it’s harmless. Successful investors manage short-term market movements so they can stick to their long-term plan and adjust when it suits them.
Here are some strategies you could try next time you’re tempted to respond to market volatility.
1. Review your financial plan
Before you make any changes to your investments or financial plan, take some time to revisit it. Your plan should centre on your goals and circumstances, so revisiting it could remind you why you chose your strategy and why sticking with it could be beneficial.
2. Reduce your exposure to the news
It can be hard to escape headlines and constant updates, but limiting your exposure might be useful. You may reduce how frequently you check the news, log on to social media, or even monitor the performance of your portfolio.
Be mindful of the source of the information as well – is the source likely to present changes to the market negatively or exaggerate the effects?
3. Look at the historical data
Investment returns cannot be guaranteed, but looking at past performance might be a useful exercise if you’re tempted to make knee-jerk decisions. Historically, markets have recovered and grown over the long term, even after sharp drops.
4. Talk to your financial planner
Finally, your financial planner can offer valuable advice as they understand your circumstances and goals. Talking through the options could highlight where bias might be influencing your decisions and offer a different perspective that allows you to remain focused on your long-term goals.
Contact us to talk about your investments
If you’d like to talk about your existing investment portfolio or would like to understand how investing could fit into your overall financial plan, please get in touch.
Please note:
This blog is for general information only and does not constitute financial advice, which should be based on your individual circumstances. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up, and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
