July’s Market Dip Sheds Light on Behavioral Finance.

Financial markets are neither logical nor 100% predictable. – especially short-term. When investing you assume some risks for a certain level of reward. If you chose not to invest, you also assume risks. If you put money under your mattress, or leave it in a savings account, the value of your savings may not keep up with inflation, making your savings less valuable. Therefore, it is important for you to know what risks you are willing to take. (Since this can change over time, review your investments annually based on your current risk tolerance.)

It was exciting to watch the financial markets reached an all-time high in July of 2024, before dropping the final week of the month. Hopefully, you are not watching your account values on a daily basis. That could drive you crazy! It also distorts your view. You cannot see the bigger picture when you are focused on the daily moves. The July pullback hurt, but most stocks were still well above their value just three months earlier. Now many stocks have bounced back towards their July highs.

The market sell-off was an emotional response to a change in market information. Investors feared a market correction, or believed a recession had arrived, because the downward revision of the new jobs numbers declined from 179,000 to 114,000. That was a larger than expected adjustment and with consumer spending already slowing, many investors reacted quickly to sell their holdings. They missed out on the quick recovery.

Investors listen to market analysts’ explanation of the probabilities, statistics and forecasts believing the numbers, charts, and formulas will reveal some logic to the market. This is they find comforting. However, many of the predictive tools are theories that have shown a strong correlation between a cause and effect, but they are not absolutes. They are observations and the ultimate timing of the move is speculative.

Even if analytics could prescribe a successful investment strategy, investors would disrupt the strategy by trying to capitalize on the strategy for their own gain. In turn, their actions would change the outcome of the original analysis. That is only one reason why markets are hard to predict.

It is important to understand that your emotions play a big role in the success of our investment outcomes. According to behavioral finance research studies, nearly 80% of investment decisions are psychological and can have a huge negative impact on your financial success if left unchecked.

The best way to protect yourself from emotional self-sabotage is to understand your emotional triggers. Below are some of the common behaviors that can get investors into trouble.

1. Herding: Herding is following the crowd which includes momentum trading which can create bubbles and exaggerates market movements. However, herding can be a positive. It can add efficiency to the market when information spreads, consensus is formed, and pricing shifts based on the shared information.
2. Anchoring: Anchoring is when an investor puts more credibility in the initial information they receive and then filters new information in relationship to the initial information.
3. Confirmation bias: This is a common bias. People like to be “right,” so they seek information that will confirm what they already believe.
4. Repetition bias: Repetition bias is powerful, and one often does not recognize they are giving more credibility to information that is frequently repeated. Just because something is stated several times does not mean it is accurate or true.
5. Activity bias: People like to take action in stressful times. It makes them feel like they are in control. Taking action also has a reassuring effect on the mind. However, the investors that jumped out of the market at the end of in July, missed the recovery.
6. Recency bias– Recency bias is when investors assume an investment will continue as it has in the past. They chase past performance which is not a guarantee of future results.
7. Regret aversion– FOMO- Fear of missing out. These investors typically get in the market after the market has rallied for a while. Therefore, they purchase stocks at the high end of a rally and are the first to feel losses when the market makes a correction.
8. Loss aversion– Loss aversion has a paralyzing effect on investors. Loss averse investors tend to delay making decisions, are reluctant to sell losers, they do not stick to a long-term investment strategies and their investment allocation is misaligned with their financial goals or timeline.
9. Over confidence: When an investor overestimates their skill and knowledge, they overtrade, ignore diversification, overlook risks, and don’t admit their mistakes.
10. Zero-risk bias: Zero-based bias is the tendency to prefer investments with zero or very low risk investments. There are not many growth opportunities in this type of investment strategy.

If you recognize any of these behavioral biases in your own investment decisions, think about how you can be more rational in the future. Know yourself. Then enact a waiting period before taking action. Be accountable to yourself regarding your emotional response to different market events and build guardrails into your investment strategy to minimize these responses.

Your financial advisor can be a great accountability resource. Make certain you ask them questions if you have concerns about the market or your individual investments