Bear markets and sell-offs evoke strong emotional responses that can lead clients to investment decision errors. Yet, tragically, clients may be unaware that their response is emotionally driven, not logic-driven. As a result, in extreme cases, a client’s portfolio can take years to recover from investment decision errors.
This article focuses on how advisors can coach clients to manage a hazardous emotional influence called “loss aversion.”
Loss aversion during a market sell-off can wreak havoc on long-term investment goals such as building a retirement portfolio. An investment decision error in the wake of a market sell-off just before or during retirement can force a client to:
- Delay retirement,
- Accept a lower standard of living,
- Return to work (if retired), or
- Chase returns by taking on excess investment risk.
We’ll unpack what drives loss aversion, identify a dangerous decision error, and illustrate a potential guardrail to remain on track with long-term investing plans.
“Irrational” Loss Aversion
We’re a logical, evolved species, right? Before you answer, consider that your conscious brain is built upon a primitive set of instincts that have changed little in the last 50,000 years. You are alive to read this article because those ancient instincts — our primal brain — led to the survival of our species.
Here’s the headline — Your primal brain is alive, you may not be consciously aware of it, and it wields emotional power beyond belief. The primal brain was and is designed for two primary functions, both critical to human survival:
- Hunting and gathering and
- Detecting and avoiding danger.
As we use our brains for far more complex tasks, including investing, these two primary functions of our primal brain can lead to investing decision errors.
For example, a “logical” investor under modern portfolio theory is assumed to seek gains with the same intensity as they fear losses. Regrettably, that notion of logic can be swept away by our primal aversion to loss. Several studies reinforce that conclusion. For example, would you bet $100 to gain $200? Assuming that each result is equally likely, the majority of survey participants would not take that bet!
Here’s your takeaway — what is rational to our conscious mind may feel completely illogical, if not threatening, to our primal instincts.
Dangerous Decision Error — Panic Selling
Bull markets, bear markets, recessions, and expansions are all part of the normal economic cycle. For example, the Dow plunged by 37% during just one month in the Covid Crash of 2020. U.S. investors saw $4 trillion in wealth evaporate in just six trading days. Investors who panic-sold near the bottom and went to cash missed out on a meteoric recovery less than three months later. The insidious compulsion of loss aversion can be a one-two punch as we’re first hit with panic selling and later hit with delayed re-entry into the stock market because cash is “safe.” The admonition that “you have to be present to win” applies emphatically to the stock market.
Yet, some intelligent investors sell in a panic. Why? Panic selling is not just logical to our primal brain; it’s an imperative response to the threat of perceived mortal danger. The visceral fear that losses will continue and the investor will be left with nothing is driven by an adrenalin-fueled “fight or flight” response. This response can overwhelm our rational, conscious brain and drive clients to sell-sell-sell without thought of the long-term consequences.
Interestingly, studies have shown that modern-day humans fear stock market losses in the same area of the primal brain as our ancestors feared being eaten alive by predators. The author has good news and bad news. Here’s the good news — the number of attacks from saber-toothed tigers has been zero for about ten thousand years. Here’s the bad news — our primal brain fears stock market losses with the same intensity as our ancestors feared being a predator’s entrée.
One of the best defenses against panic selling is guidance from you — the financial advisor. A savvy financial advisor is uniquely positioned to help clients see market fluctuations from a longer-term perspective. These perspectives can help clients address their unconscious primal fears and avoid panic selling. An advisor may even coach clients to see opportunities to buy good stocks as they go “on sale” during a sell-off.
Loss aversion is but one of the powerful psychological influences that drive clients to investment decision errors. Click Behavioral Finance for coaching resources to guide clients through these treacherous influences.