How to avoid emotional reactions when the markets crash

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Over a third of people that sold off shares after the market crash now own fewer than they did in early 2020, compared to 12% who own more.


During the early stages of the COVID-19 crisis, 8% of people either sold some of their investments or took their money out of the stocks markets, new research by behavioural finance experts Oxford Risk reveals.


The stock markets have clawed back much of their losses, but of those investors selling off shares 29% have not reinvested any of this money back, while only a tenth have reinvested 50% or more.


In a normal year, emotional investment decisions can cost an average of 3% in returns, but in the current crisis it’s expected to be even higher due to the high volatility.


“In every decision we make there’s a sort of tension between the sensible thing to do for our long-term financial needs and the comfortable thing to do for our immediate emotional needs – and these two things are very often torn apart,” Greg Davies, head of behavioural finance at Oxford Risk, told Proactive.


“As humans we tend to deviate away from sensible towards comfortable. One of the ways we do that is selling at the bottom, but also buying at the top of the overtrading, sitting on cash for too long and doing nothing. All of these are ways in which, as humans, we effectively buy ourselves short term confidence in the cost of long-term returns.”


The importance of resilience


At the start of the pandemic, retail investors saw stress coming at them from multiple directions – health, work, finances – while sitting at home with perhaps more time on their hands than usual, which ended up shortening what Davies calls the “emotional time horizon”, causing people to focus on the present.


While some people may have needed the extra cash, several investors may have taken money out beyond their actual needs for emotional reasons.


According to Davies, this is more likely to happen to people with personality types characterised by low composure, which makes them focus on the here and now, and by stronger impulsivity.


To make it through a financial crisis, investors need to build up emotional resilience alongside their financial skills to prevent emotional reactions that could dent long-term returns.


What to do


Retail investors who tend to have these reactions don’t have to necessarily have to change their portfolio to low-risk stocks, Davies noted, but can look for advice to prepare a set of rules when they are calm and collected.


Having done so, in times of crisis and volatility they can follow the framework of rules instead of succumbing to emotional behaviours.


While avoiding a super high-risk profile should be preferred, financial advisors should also communicate in a way that soothes investors and stick to their sets of rules.


“If we focus on communication on the detail and on short-term time slices you’re never going to get people to look in the distance,” Davies told Proactive.


“That aspect of reviewing the portfolio and controlling the information that you present to people can make a huge difference to someone’s emotional state, even without changing anything.”


It’s always a good time


For many people, the bigger long-term cost is keeping their money in their pockets and finding excuses not to invest.


When markets crash, there’s always a small portion of people that will take advantage of cheaper stocks, but the natural response for most people is to sit tight, hold onto the cash and wait for the crisis to end.


“The costs are not immediate, because I haven’t lost any money: it’s still sitting in the bank account, but the cost of that may be more long-term if I amplify this nervousness about investing,” Davies concluded.

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