A closer look at typical investor behavior shows that reactions to market swings are complex and more nuanced than the simple adage that investors tend to "buy high and sell low." It is important to understand where these emotions come from so that you can take control of them and take advantage of the opportunities volatile markets can afford. Let's explore the four distinct phases of emotional investing tied to market swings, each with unique emotional responses.
As markets rise, a feeling of optimism, enthusiasm and even euphoria takes over as individuals see their account balances grow and read about the market rallies. These feelings build during a prolonged economic expansion or market rally.
But this is also a point of huge financial risk. Investors start to believe excessive returns are the norm. Their success makes them start to feel that they can beat the market and tolerate high levels of risk, according to Richard Thaler, Nobel Prize winner and professor of Behavioral Science and Economics at the University of Chicago Booth School of Business.
As markets near and then pass their peak—a moment that's extremely difficult to pinpoint—investors often vacillate between anxiety, asking themselves, "is this the top, are we in a bubble, should I get out now?" and denial, "this is only a temporary downturn."
This second phase kicks in because the market is no longer meeting investors' unrealistic expectations. These emotions, especially fear and despair, can cause people to start to think about switching out of riskier assets or pulling out all together, Thaler explains.
As markets continue to drop, panic and discouragement take over. Suddenly investors want out, often when their losses will be the most severe. The realities of a bear market are clear and investors feel desperate.
They may want to pull out completely, afraid of further losses. Those who don't pull out become despondent and wonder if markets will ever recover, according to Hersh Shefrin, economist, leading expert in behavioral finance, and author of "Behavioral Risk Management."
It is in this phase that investors often fail to recognize that the bottom is actually the time when they can take advantage of the maximum opportunity.
Stay calm and remember that pulling out at the bottom is a bad idea. You may suffer losses and miss out on the market’s inevitable rebound.
In this stage, just as the market starts to rebound, investors may still be cautious and worried, wondering if the upswing will last. They may still be reluctant to reinvest at this point, even though prices are still relatively low and upside potential exists.
Then, as markets continue rising well into their rebound, investors start to feel some relief and hope, just as prices rise and large gains have already been realized.
When the market starts to turn, consider taking advantage of the current low prices, and look for some solid buying opportunities before it’s too late.
Content provided by New York Life Investments
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