Key insights
- The article discusses how behavioral biases, particularly loss aversion, can negatively impact investment returns. Investors who react to short-term market declines by selling low and buying high tend to underperform. The DALBAR QAIB report quantifies this performance gap, highlighting the significant cost of emotional decision-making. The advice is to remain disciplined and avoid overtrading, especially for long-term investors.
In college, one of my favorite topics to study was behavioral finance and cognitive bias. It essentially covers how investors' emotional framing and decision making can negatively impact their investment returns.
One of the biggest biases is loss aversion. It says that the pain of experiencing losses is much greater than the joy of experiencing gains. Generally speaking, when losses on investments become part of the equation, rational thinking can go out the window and emotional thinking can take over.
Historically, the data shows that people who react to short-term events and overtrade their accounts tend to do more damage than good. The cost to portfolio returns can be significant, but the temptation can be avoided.
Anecdotally, we have a pretty good idea of what happens when the markets start to decline. The investor sees the value of their account declining, decides to try to stop the bleeding, and gets out of the market. When they see prices rising again and assume all is good again, they get back into the market.
The problem is that this behavior essentially sells low and buys high. Investors capture the loss and miss out on the rebound. Studies have put numbers around the impact of this behavior and the results aren't good. DALBAR's annual Quantitative Analysis of Investor Behavior (QAIB) report is perhaps the most popular study. Here are the results from 2024:
Even on modest investments, that performance gap can result in thousands of dollars lost over time. As a part of a regular investment plan where more significant investments are being made, such as a 401(k) plan, it can be hundreds of thousands of dollars lost. As Benjamin Graham once said in The Intelligent Investor, "The investor's chief problem -- and even his worst enemy -- is likely to be himself."
If you're a long-term buy-and-hold investor with years to go before you need the money, the answer is simple. Do nothing. Volatile periods like the one we're in are normal when it comes to stock investing. Ideally, they should be ridden out to capture the full return on the investment. No one, not even the professionals, know what the market is going to do tomorrow.
If these swings are still too painful to watch, reassess your risk tolerance. Consider investing in a more conservative mix of investments that helps mitigate some of the more extreme highs and lows.