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Investor Psychology: Why Short-Term Volatility Can Drive Behavior Despite Long-Term Investment Horizons

Karen Manczko portrait photo

   By Karen Manczko
   Director, Institutional Relationships
 
   November 19, 2020

One of my favorite things about investing is how closely it intertwines with fundamental human behavior.

Though I have been professionally trained—and spent most of my career—in investment management and financial services, I earned my bachelor’s degree in Psychology from the University of Illinois at Urbana-Champaign.

While in college, I spent time working for The School of Psychology, helping PhD candidates run their studies and compile their analyses. One particular study I supported focused on counterfactual thinking. In the world of psychology, this describes the human tendency to create possible alternatives or outcomes to certain events that one has already experienced.

In other words, counterfactual thinking creates “what if” and “if only” scenarios. These include upward thoughts (how the situation could have been better) or downward thoughts (how the situation could have been worse).

For example, a famous study involving Olympic medalists found that individuals who win bronze medals tend to be happier than those who win silver medals. For silver medalists, the contrary thought is “if only” they won the gold medal (upward counterfactual thinking), whereas bronze medalists think about how they could have won no medal at all (downward counterfactual thinking).

Counterfactual thinking is common in the investment world. To use a personal anecdote, my husband recently recalled his decision to sell his Amazon stock in 2009. He decided at the time to consolidate his investments in Amazon and Yahoo by investing in only one of the companies, and ultimately, he decided wrongly!

These types of mistakes frequently happen to investors. For example, because of counterfactual thinking, my husband’s latest thought was to sell the stocks in his portfolio that were not producing solid returns so he could invest the proceeds in Amazon and try to benefit from the stock’s great performance. His “if only” reflections on the past turned into “what if” thinking about the modern day.

It is easy to understand how one might apply the same thinking to the COVID-19 market selloff earlier this year. U.S. equity markets declined 34% in a matter of 16 trading days, ending a decade-long bull market just months after the S&P 500 gained 31.5% for 2019. How many investors are thinking “If only” I sold at the top and bought back at the bottom?” or “What if” I hadn’t missed that buying opportunity?

This sentiment continues. Despite a strong rebound from early 2020 volatility, investors have asked me lately if they should consider making a change in their investment allocations due to the uncertainty surrounding the COVID-19 pandemic, the political environment, or the low interest rate environment—among other reasons.

Of course, the market likes certainty and the outcomes from current events are far from certain. But in my view, making large shifts in your investment portfolio should only occur if you can honestly answer yes to any the following questions:

  • Did my investment goals and objectives change?
  • Did my investment time horizon change?
  • Do I expect changes in cash flow and/or projected cash flow?

Let me demonstrate this in a real-world example. A pool of assets originally designated to fund a church’s children’s ministry were re-designated to fund a roof repair. The church unexpectedly needed to fund a near-term project with assets intended to support a program in perpetuity. This means that near-term market volatility could adversely impact the church’s near-term need. Hence, the church’s investment allocations should clearly change.

For those not experiencing material changes in their investment goals and objectives, it is important to avoid acting on present day uncertainty. History tells us markets tend to rebound after meaningful declines. We must consciously avoid our counterfactual thinking, ignore our internal “what ifs” and “if onlys,” and remain focused on the benefits of a disciplined and diversified long-term investment strategy.