Investors are reeling from the crash of global markets. But here’s the bigger risk right now for investors: that those losses will lead them to act in a way that will result in even bigger losses.
It doesn’t have to be that way.
First, to understand why people make this mistake, it helps to revisit an old bet first introduced by the Nobel laureate Paul Samuelson. The bet goes like this: I’m going to flip a coin. If it lands on heads, you’ll win $200. However, if it lands on tails, you’ll lose $100. Do you accept the bet?
If you’re like most people, you reject this gamble. That’s because for many people the pain of losing $100 exceeds the pleasure of winning $200. Put another way, losses hurt twice as much as gains feel good, even when the potential loss is relatively small and doesn’t pose much risk.
Such “loss aversion” helps explain why a market correction can be so unpleasant that it leads to panic selling. We are wired to hate a portfolio full of red ink.
But many investors aren’t just loss-averse. They are extremely sensitive to short-term losses, a phenomenon Richard Thaler and I refer to as myopic loss aversion. If someone is myopic, they are nearsighted, meaning they can only properly focus on things that are close by and everything in the distance is blurry. Prof. Thaler and Ishowed that many investors are nearsighted when it comes to their investment performance, only able to focus on recent events, even if it significantly reduces their long-term investment performance. These are the investors at highest risk of costly panic selling.
Do you suffer from myopic loss aversion? Here’s a short assessment I’ve developed to determine whether you’re likely to buy high and sell low during a market panic.
1) In normal times, how often do you evaluate the performance of your investments?
A) Daily or weekly
B) Monthly or quarterly
D) Every few years
The more often you check your performance, the more likely you suffer from myopic loss aversion. That’s because you feel the pain of the losses more frequently and potentially overreact by panic selling. The problem is not necessarily the losses, but how often we mentally account for them.
2) I often set a goal but later choose to pursue a different one. Is this:
A) Very much like me
B) Mostly like me
C) Somewhat like me
D) Not much like me
E) Not like me at all
This question was borrowed from the “grit” assessment developed by Prof. Angela Duckworth and colleagues. She and others have shown that grit—the willingness to persevere for a long-term goal, especially when it’s difficult—can help predict a variety of outcomes, from academic success to creditworthiness.
If you often give up on your longer-term goals, you’re probably at higher risk of selling low during a market decline. The pain of the short-term loss is going to make you give up on your long-term investment strategy.
In contrast, those who tend to stick with their goals are probably more likely to shrug off the market losses. This is akin to gritty long-distance runners ignoring the aches of their muscles so they can finish the race. It’s a useful mind-set. For most of us, investing isn’t a sprint—it’s a marathon.
3) Do you use any apps to regularly check on the performance of your investments?
Although smartphones can make investing more convenient, that convenience becomes problematic during periods of high volatility. That’s because people tend to be more impulsive and emotional on mobile devices. Prof. Shiri Melumad at Wharton has shown that smartphones lead people to generate more emotional content, while scientists at the University of Texas and University of California at San Diego have shown that simply having your mobile device nearby can reduce working memory and cognitive capacity.
My concern is that these trends can also make us more likely to sell during a panic. You no longer have to call your adviser or write an email. Instead, you can just pull your phone from your pocket and, with a few quick finger taps, liquidate those funds that have fallen in value.
What should you do if, based on this short assessment, you appear to be hypersensitive to short-term losses.
The most immediate thing you should do is not look at the market. Immediately delete all financial apps from your phone. This is also an opportunity for financial advisers to become a kind of “app doctor,” helping clients create a digital environment that encourages longer-term decision making.
However, if you simply can’t resist looking at the market, then it’s important to take the following three steps to change the frame of the picture.
-Zoom out, which involves changing the format of your performance metric. If you are checking your 401(k), many financial institutions now allow you to see your account balance in terms of projected retirement income, as opposed to total wealth. Projected retirement income not only gives you the bigger picture—it’s also much less volatile in response to market swings.
Consider an investor with a $1 million portfolio, 60% in stocks and 40% in bonds. Let’s further assume that the portfolio’s stock investments have dropped 30% from their recent high, and bonds have been relatively flat. This means that the portfolio is now worth roughly $820,000. If we assume an annual withdrawal rate of 4%, just to keep the analysis simple, then retirement income went down from $40,000 to $32,800 a year, a decrease of 18%.
However, it is important to factor in Social Security benefits, as those didn’t go down. Assuming a retirement age of 66, Social Security benefits could amount to $36,000 a year, depending on your earnings history. In this case, total retirement income went down just 9% (from $76,000 to $68,800). The bigger frame shows a far less dire picture than the stock market alone would suggest.
-Frame the market decline as an opportunity, rather than a challenge. It’s not a crash—it’s a sale. I am not necessarily advocating to time the market if the Dow drops to say 15000 or 12000, as I surely don’t have a crystal ball. But the mere act of rebalancing portfolios amounts to a concrete plan to buy more stocks “on sale” as markets keep declining. Advisers should also focus their clients on rebalancing, as opposed to selling.
-Frame the market correction in terms of finding solutions, which help us get a better perspective on the practical implications of the crash.
Let’s return to that investor dealing with a 9% decline in his or her total retirement income. The investor can easily compensate for the market drop by making some small adjustments to the retirement plan.
One option is to implement a process I call the 1-2-3 approach. It goes like this: If the investor retires one year later than planned, and saves one percentage point more a year for the next two years (if still working), and reduces planned spending in retirement by just 3%, he or she will have fully made up for the recent market downturn, even if the market never recovers.
The larger lesson is that, by identifying those who are most sensitive to the current downturn, and helping them think broadly about their portfolio, we can help them worry less about the daily swings of the market. That, in turn, will prevent those investing mistakes that worsen the panic and cost people serious money.
Uncertainty isn’t new. But panic hurts everyone.
Dr. Benartzi (@shlomobenartzi), is a professor and co-head of the behavioral decision-making group at UCLA Anderson School of Management and a frequent contributor to Journal Reports. Email him at firstname.lastname@example.org.