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What You Need to Know About Behavioral Finance Thumbnail

What You Need to Know About Behavioral Finance

When the markets move—for better or for worse—it can be easy to want to act. In a bullish environment, you may be feeling lucky and tempted to “double down” or jump on the bandwagon to ride the earnings wave. But when values turn south, you may be the first to jump ship and stay out of the market altogether “until conditions improve.”

But this is far more than conjecture, and don’t just take our word for it. This is repeat investor behavior that has been documented by an entire field of study known as Behavioral Finance. Behavioral Finance seeks to understand how psychological influences and biases affect the financial behavior of investors and financial practitioners.

What they’ve uncovered is easy to understand, but difficult to hear. In other words, even with this information in hand, investors typically tank without the advice or guidance of a professional. First, let’s take a dive into the basics. 

In general, behavioral finance has found that investors lack self-control, act irrational, and rely on personal biases rather than the fundamentals of economics and finance to make critical financial decisions. They allow emotions to drive-decision making and make costly errors. The result? Loss of capital in the near-term and wealth-building power over time.  

Unfortunately, millions of Americans made these same behavioral finance mistakes this past year in the wake of the original COVID-19 market crash in March of 2020. For many, these losses will be difficult to recover. 

Many investors followed a pattern that went a little something like this: 

March 2020: After two weeks of turbulence, the financial markets closed down on March 6th, 2020. The yield on 10-year and 30-year U.S. Treasury securities hit new record lows by the 9th, with the 30-year securities falling below 1% for the first time in history.

Mid-March 2020: Joe Investor liquidated his 80/20 model portfolio in light of COVID scares and frenzied media headlines warning of a recession.

April 2020: Joe Investor bought back a 50/50 allocation as markets begin to pick up, but despite the riskier allocation has already forfeited significant buying power as a result of the original liquidation. 

November 2020: Joe Investor switched to a less aggressive 30/70 model over election concerns and missed out on an aggressive rebound. 

The investor panics and sells, realizes they made a huge mistake as the market starts rebounding, and attempts to restore by buying back at a more aggressive position.

Recovery from Loss is Harder

Unfortunately, market volatility is a two-way street. The harder the fall, the greater the climb. This is because loss and gain are not V-shaped. For example, a 10% loss take 11.11% to recover to a “break even” point. A 15% loss—17.65% to recover. For every percentage point in capital that is lost, it takes exponentially more to get back to where you started. 

Had Joe Investor “rode out” the rough pandemic patches and the election-tethered panic by staying invested, he or she would be enjoying a significant gain rather than trying to inch back from a significant blow. 

Missing Out on the Market’s Best Days

The reality of recovery is a hard pill to swallow, but the most devastating blow to Joe Investor’s portfolio will be missing out on the market’s best days. Investors who get spooked and pull out of the market prematurely trade their investments in for cash, then don’t have a stake in the game when numbers swing back in their favor. According to a study conducted by JP Morgan looking at market performance over a 20 year period, if you missed out on the market’s 10 best days your overall return was cut in HALF! That’s an incredible disadvantage for missing 10 days out of a 2-decade period. 

Even so, you would think the risk of being a part of the market’s best days would overshadow the risk of potential loss? But that’s tough to accept when everyone you know (except your financial advisor, hopefully) is warning against staying invested. Media headlines, your colleagues, and your own personal fears could be the factors that push you over the edge. This is one of the many perils of DIY investing—not having someone to guide you through the tough times.

Investors with an Advisor Fare Better

It isn’t surprising then that Vanguard research indicates investors who ally with a financial advisor tend to outperform those who go it alone by an average of 3%. The main reason is that above-average advisors are present for their clients when things get tough. They are always monitoring their portfolios and looking out for the client’s best interest in changing market environments. They protect portfolios over time and mitigate irrational behavior when emotions want to steer the ship in an unfavorable direction. 

At the heart of it, money doesn’t make decisions. People do. But, our emotions often don’t have our own best interests in mind (despite the facts and figures that support it). Your advisor is the person who can—and should—bridge that gap.

Are you allied with a financial professional you can trust to guide you through the tough times? Who will keep an eye on your portfolio and alert you when moves need to be made? If you are looking for this type of partner, the advisors at RiversEdge Advisors can help. We specialize in working with business owners through all financial climates to position the best possible outcome for their situation. Schedule a call with one of our advisors today to learn more.