Stocks, once again, are falling. Between raging inflation, rising interest rates, and the war in Ukraine, there is more than enough uncertainty to go around.
If you are in a globally diversified portfolio you might be down 10-20%1. While uncomfortable, most people don’t fear a 10-20% decline. What is scaring investors right now is the prospect of -15% turning into -30%2. If you’re nodding along, be assured, this is normal. In fact, in times like these, your brain is hardwired for anxiety in two specific ways.
1. Recency Obscures Our Objectivity
What happened most recently heavily influences your opinion on what will happen next. This is known as recency bias, which Carl Richards, creator of the Sketch Guy column in the New York Times, illustrates beautifully:
It’s easy to apply recency bias today: “Scary things are happening in this crazy world, which is causing stocks to fall, and the world will only get crazier, so stocks must fall even further.”
But, on its own, suspecting further declines may not be enough to compel you to sell stocks. A second brain quirk supplies the extra distress that causes investors to capitulate.
2. Humans Despise Uncertainty
Researchers have found that uncertainty significantly increases people’s discomfort. In one study, participants were hooked up to electrodes capable of delivering a small shock. When told there was a 50% chance they’d receive a shock, participants showed greater stress than when told with 100% certainty that they’d be shocked.
Ema Tanovic, psychologist at Yale, explains: “If we think in purely rational terms, this does not make sense. A 50% chance of a shock should be half as anxiety-provoking as a 100% chance if all we care about is the threat itself. But this is not how our minds work.”
In another experiment, participants played games in which they chose between a small, low-probability reward available immediately, and a larger, higher probability reward available after an uncertain delay. Only 37% of participants could handle the uncertainty, opting instead for the immediately available outcome, despite the smaller reward.
Think about that – most people are willing to forgo greater rewards just to avoid an anxious state of uncertainty.
Consider the implications of these two tendencies for investors today: Recency bias has us fearing that only bad news and negative returns are on the horizon. And, desperate for relief from the market’s uncertainty, we’re compelled to yank money out of stocks after they’ve fallen, despite universal knowledge to buy low, not sell low.
I can present 100 years of market data showing that, for a diversified investor, every bear market has proven temporary. I can also show how and why stocks are probably going to get better even while uncertainty in the world gets worse. That post, filled with data and charts, is a post for another day. For now, if you are tempted to sell stocks, it is first important to acknowledge the brain quirks behind that perfectly human yet irrational impulse.
1These three Vanguard funds are globally diversified portfolios of varying stock/bond allocations.
Vanguard LifeStrategy Growth is 80% stocks and 20% bonds (click link for more detail).
Vanguard LifeStrategy Moderate Growth is 60% stocks and 40% bonds.
Vanguard Lifestrategy Conservative Growth is 40% stocks and 60% bonds.
2Your experience of the current market environment depends on how you’re invested. If you went all-in on the high-flying growth darlings of the last few years, shield your eyes, because this is a massacre:
Disclaimer: Truepoint Wealth Counsel is a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & Form CRS filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice.