New research from Dr. Rui Yao, an associate professor of personal finance at the University of Missouri, identified risk factors for people who are “more likely to make investment mistakes during a down market,” and found that aversion to losses was the key character trait.
If you weren’t so worried about losing money, it might happen to you less often.
That’s because losses, according to a new study, occur when people are so desperate to avoid them that they blunder into them.
It’s like a child worried about missing a fly ball or dropping a pass, or a newlywed husband fearful he will drop his new bride as he carries her across the threshold; once it’s in the mind — and the person starts to adjust thinking drastically to avoid it — that’s when the trouble starts.
The new research from Dr. Rui Yao, an associate professor of personal finance at the University of Missouri, identified risk factors for people who are “more likely to make investment mistakes during a down market,” and found that aversion to losses was the key character trait.
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The issue, Yao said, wasn’t about playing defense or positioning a portfolio to minimize volatility and potential downturns, but rather with investors who moved financial assets into a cash position during a down market without some income interruption or increased spending need driving the decision.
“The real mistake is being inconsistent,” said Yao, whose study was based on 2008 crisis financial transaction data previously used by Ameriprise Financial and the Financial Planning Association in research designed to look at the value of financial planning. “If someone has a plan for how they are going to protect themselves and they have that system and they follow it whether the market is up or down, then the moves they are making when the market is bad are still consistent with their strategy.
“It’s when someone says, ‘This is so bad, I can’t stand it anymore,’ ” Yao said. “Those people go to cash to avoid losses, but they make things worse because they sell when things are down and don’t buy until they are back up. … That’s a form of loss too.”
So too are taxes and transaction costs that are incurred during the moves, Yao noted.
“People are so loss-averse that they create costs — which affect their portfolio like a loss too — and they wind up with opportunity costs too, and that happens whether the market does what they think it will do or not,” Yao said. “During a down market, every mistake you make is magnified. It’s bigger and harder to overcome.”
Investors exacerbate the problem when they look at their portfolio only from its peaks, as if every dollar of gains that shows up on the statement is a real loss — rather than a paper profit — as the market readjusts. That tends to speed up how quickly an investor gets panicky, she said.
As devastating as panic can be, Yao said it’s also a mistake to bail out from the other end of the spectrum, with supreme confidence in being able to call the market and sidestep a downturn.
Yao agreed that the overconfidence these days shows up in investors who are so sure a bear market is about to happen that they can brag about being on the sidelines. While those champions of the chat boards and online communities sound fortunate to be on the sidelines in the middle of turmoil, Yao noted that the long-term results don’t turn out in their favor.
“They gain confidence because they can say that they are right, and they might be right now,” Yao said, “but they have adopted a short-term investment approach and they are market timing and trading more, which rarely pays off.”
Yao said that investors should be using current conditions to test their emotions, to see how they are reacting to a down market and to foresee if there is a coming point where they head for the hills, or where they would be so certain that the market is crashing that they would confidently move to the sidelines.
“This market is going to show you a lot about your risk tolerance, and whether you really understand how you feel and react to risk,” Yao said.
Ultimately, the research showed that investors who want to be defensive and protect themselves against downturn need mostly to guard against the knee-jerk reactions, and the emotions that come with nervous markets.
That means having a plan or strategy or system, and Yao didn’t advocate any specific plan so much as making sure that there is a reason behind them, whether that is selling because a newsletter you follow issued a sell signal, a trend-following strategy signaled a sell when a fund fell below its 200-day moving average, or because a decline triggered a stop-loss and sold a position to protect a profit.
It’s normal to want to avoid losses, Yao noted, but investors who build a financial plan typically diversify their assets and take other steps to mitigate the effect of declines, rather than yanking everything out at some sign of trouble.
“Markets aren’t consistent,” Yao said, “but the way investors react to the market can be, and should be.”