Dealing with the Emotions of Stock Losses
Consider the emotional Captain James T. Kirk and the purely logical Mr. Spock...
I used to watch reruns of the original Star Trek back in high school. In case you're new to this, the captain of the Enterprise was a highly emotional leader, but his #1 lieutenant was a purely unemotional, rational person from the planet Vulcan.
This came to mind lately as I’ve been having numerous conversations with clients concerned about the losses in their portfolio values due to market declines. This is understandable because nobody (myself included) is immune to those emotions. However, our emotions can lead us astray.
Consider the following situation: Person A invested in a high-flying stock that increased by 67% over a year. Person B invested in a balanced 60/40 portfolio that grew by an above-average 13% during that period. Now, suppose the market falls, as it has over the last month. The high-flying stock drops by 31%. Ouch! However, the 60/40 balanced portfolio only falls by 1%. What's the rational response? What should they be feeling?
Despite the losses, person A ultimately gained 15% in the high-flying stock, while Person B gained 12% in their balanced portfolio.
If these individuals were robotically rational, like Mr. Spock, their emotions would be strictly tied to the total percentage of gain or loss since the initial investment date. Both people should be delighted. They both beat the long-term averages! However, because we are not purely rational creatures, I bet both are unhappy with the decline, with Person A feeling much greater regret and, possibly, a real pit in their stomach. Earthlings are not like Mr. Spock!
"Captain, you're being irrational again..."
Behavioral finance discoveries have been the source of several Nobel prizes this century, including Kahneman in 2002, Shiller in 2013, and Thaler in 2017. Academia has continued studying the unconscious emotions that affect our financial perspectives. In my view, there is no place where those findings are more relevant than when the market is falling. Here are three well-known cognitive biases that explain why we feel pain when the stock market falls.
1. Anchoring Bias: The previous high water price embeds itself as a powerful mental “anchor point” in our minds. Once we emotionally anchor to the previous high, subsequent declines feel like a "loss" even when the stock is still in an overall gain position.
2. Endowment Effect: Once emotionally anchored to a peak stock price, we feel like it's “money in the bank.” Any subsequent declines feel like money is being taken from us, even though the money was only unrealized paper gains.
3. Loss Aversion: We feel the pain of losses much more intensely than the joy of equivalent gains, so even small losses can feel emotionally painful and cause us to respond more intensely than merited ("Screw this - I’m getting out of the market and selling it all!").
It’s essential to be aware of these cognitive biases so we can behave more rationally, which contributes directly to the long-term success of our investment portfolios. One of my favorite sayings is from the late great John Bogle of Vanguard fame. When referring to stock market declines, he said, “Don’t just do something, stand there!”
"Don't just do something, stand there!"
Disclaimer: The information provided in this blog post is for educational and informational purposes only and does not constitute specific financial, tax, or legal advice. All investing involves risk, including the potential loss of principal. Market data and statistics cited are believed to be accurate as of the date of publication, but are subject to change. Please consult with a qualified financial professional to discuss your individual circumstances and risk tolerance before making any investment decisions.