Time and time again, investors sell into falling markets, and many struggle with the decision of when to return.Nuthawut Somsuk/iStockPhoto / Getty Images
Sign up for the Globe Advisor weekly newsletter for professional financial advisers on our sign-up page. Get exclusive investment industry news and insights, the week’s top headlines, and what you and your clients need to know. For more from Globe Advisor, visit our homepage.
Investment risk is defined in technical terms with mathematical ratios such as standard deviation, the Sharpe ratio, beta and R-squared. In addition, each asset class has its own set of risks. Equity investors must understand the “trinity of risks” (business, valuation and balance sheet) of an individual enterprise; also, there are risks associated with industry sector, geography and market capitalization. Fixed income investments, for their part, have interest rate and default risk, among others.
These analytical risks are important. However, even the father of security analysis and quantification, Benjamin Graham, observed that “the investor’s chief problem – and even his worst enemy – is likely to be himself.” It’s not the analytical mistakes and risks that derail investors; rather, psychology is the risk that usually matters most.
For most investors, risk is an emotional experience that can’t be measured easily, analytically, but is all too real. Risk tolerance questionnaires that serve as guiding documents to delineate how much financial risk a person is willing to assume and the suitability of certain types of investments can give a false rating.
Comfort with higher risk is more likely to occur in tranquil periods or a bull market. It’s only during periods involving tail risks – extreme and unpredictable events such as the COVID-19 pandemic in 2020 or the global financial crisis in 2008-09 – that investors discover their “true” risk tolerance.
These extreme events trigger panic selling. If that results in capital losses and breaking the investment compounding cycle, it becomes a major risk.
Time and time again, investors sell into falling markets, and many struggle with the decision of when to return. The ease of online trading that enables investors to transact on their mobile phones makes it more difficult to put the brakes on emotionally driven behaviour.
A recent survey conducted in the U.S. found that people check their phones 144 times a day, while another found that at least half of investors check their investment performance once a day or more. This compulsive behaviour can lead to something called “myopic loss aversion” – a greater fixation on losses over gains leading to ill-considered trading actions with negative long-term consequences. A willingness to be uncomfortable with current market conditions but still stay the course is a habit worth developing.
The flip side of panic selling is panic buying. When the market, or a stock, is rising rapidly, investors fear missing out on further gains. They may dive in at any price without regard to the risks.
We tend to internalize trends. During a bear market, investors anticipate price contraction; in bull markets, investors expect price expansion. That’s the context in which we make decisions.
It’s hard to overcome our basic hardwiring. The survival instincts of our ancestors were honed through millennia. Quick reactions to threats often meant the difference between life and death. When humans observed others in their group panicking, it served as an alarm system, indicating immediate danger without requiring each individual to perceive the threat directly. Those more attuned to these cues were more likely to survive and pass on their genes.
We inherited these instincts. But in the context of modern financial markets, herd behaviour is a risk, especially during extreme periods when prices are dislocated from intrinsic value.
The tendency to panic when others do can lead to impulsive decisions such as selling off investments during market downturns. That illustrates a fascinating aspect of human evolution: Traits that once ensured our ancestors’ survival can sometimes manifest as less beneficial behaviours in today’s vastly different environment.
It’s tempting to emulate the investment choices of media pundits or social media influencers, but remember that there are many ways to make – and to lose – money. Each of us has unique goals and tolerances to real or perceived risk.
Investors must select a strategy that suits their temperament and one they can maintain regardless of short-term market gyrations. The ideal risk tolerance is easy to figure out: Select investments that align with your financial priorities without causing you to lose sleep. If you’re losing sleep, it’s a clear sign you’ve taken on too much risk.
Felix Narhi is chief investment officer and portfolio manager at PenderFund Capital Management Ltd. in Vancouver.
For more from Globe Advisor, visit our homepage.