Money is emotive. The reason for this is because of what money represents in our lives. It represents status, power, opportunity and limitations. For most, it represents a life they want to live. So, when the market goes into the fastest decline in recorded history, it threatens our life goals (represented by money) and understandably amplifies emotions such as anxiety and fear.
Scientists say that fear and our response to fear, can save us when faced with physical harm. This was super handy in the caveman days but can be a hindrance in our modern lives.
Ahmad Hariri, professor of psychology and neuroscience at Duke University believes that “Change has occurred so rapidly for our species that now we are equipped with brains that are super sensitive to threats but also super capable of planning, thinking, forecasting and looking ahead. So we essentially drive ourselves nuts worrying about things because we have too much time and don’t have many real threats on our survival, so fear gets express in these really strange, maladaptive ways.”
As financial planners, we often see how destructive fear can be when it comes to making investment or money decisions. Typically, we respond to fear in one of three ways: fight it, freeze or run away. Each of these natural responses may influence your behaviour and decision making.
How do you respond to fear?
These are the people that want to double up at the bottom of the market in an attempt to regain losses. This response may lead you to punt a share or interesting story hoping to make a quick buck. This response, if not managed or moderated can be risky and destructive.
However, if managed well, this response can help you to see opportunities where others may be afraid to go.
These are the people paralysed by fear. For them, it’s impossible to make decisions. They freeze. We often see this with people who are going through traumatic life transitions such as the death of a spouse, or who have been diagnosed with a life-threatening disease or are getting a divorce. Some decisions cannot be put off and this response can be very destructive at those times.
In the case of a major market crash, this response may be a blessing in disguise. If you are a long-term investor with a well-diversified portfolio, doing nothing would be the best response.
These people want to avoid pain at ANY cost. Studies have shown that the pain of loss is physiologically twice as powerful as the pleasure of gaining. For this reason, people react to losing money more dramatically than gaining money. When you want to avoid pain it invariably means selling out of the market when it hurts, like now. This is a behavioural bias called loss aversion.
Loss aversion bias leads investors to timing the market by selling out when it looks dangerous and buying when they feel safe. This can also be very destructive because you will buy when there is good news around and the market is typically already high and sell when there’s bad news around and the market has typically already fallen far.
This can be easily seen in the example below from Morningstar. Here they show the returns you would have received if you were invested in the South African share market from 1995 to 16 March 2020. Their research shows that your annualised return would have been roughly 12% per annum. If you were out of the market for a mere 25 days (which seems insignificant over a 25-year time period) your return would drop by half to 6% per annum. This is a very substantial reduction and illustrates how difficult it is to get the timing right. The more ‘good market days’ you miss the worse it gets.
Few people will admit to taking any of these actions based on fear. We rationalise our fears. And it is normal to do so. We can often find good reasons for our actions. Our current situation a case in point: there are plenty of good reasons to react right now. In some cases, taking action is necessary but, in most cases, your long-term financial plan should not be changed drastically.
Good financial advisors are trained to identify and manage these behavioural biases. Another longstanding study from Morningstar shows that advisors can add as much as 2% per annum (in USD) to investor returns by offering sound advice and keeping clients invested.
So, what should we do?
I’d like to end with the words from Leon Hoffman, co-director of the Pacella Research Centre at the New York Psychoanalytic Society & Institute. He says, “Our culture valorises strength and power and showing fear is considered weakness. But you are actually stronger if you can acknowledge fear.”
Uncertainty creates fear. This pandemic is non-discriminative and has touched every life across the globe. We are all fearful. Acknowledging this is already half the battle won.