Investing in the stock market is not only about knowing the fundamental values of businesses, but also it is about staying mentally tough to endure the volatile periods. Part of staying mentally tough is the psychology of the markets and investors. For one thing, it is important to recognize that the stock market is a crowded and crazy place. In its craziness, the stock market is awesome because it allocates capital from the public to businesses. On the other hand, it is almost impossible to know at once what everyone is thinking about doing. The stock market is a chaotic place, therefore is very random.
One thing that investors can do to maintain mental toughness in the stock market is to take care of the things they can control. It is impossible to control the supply and demand of stocks, so volatility is not controllable. But the one thing investors can control is their mind. This is particularly important in the current weeks, when the market's volatility (as measured by the VIX index) has been pretty high and the S&P500 (NYSEARCA:SPY) suffered a correction.
The motivation of this article is to share two important psychological aspects that investors can control. By knowing this, investors should be able to have more psychological control in a chaotic investment environment. The two psychological aspects are:
- Status quo bias, which refers to maintaining a comfort zone
- Regret aversion bias, which refers to the lack of action or sometimes the rush of action
Status-quo bias - maintaining the comfort zone
This behavioral bias is very prevalent in the stock market. It's also a bias that has more than one explanation. For one thing, it refers to the idea that investors have a comfort zone and that it is difficult to leave that comfort zone. When considering asset allocation, it is very easy to maintain the same allocation for a long time. However, sometimes changes in asset allocations might be beneficial for several reasons. Both assets and investors tend to change their prospects with time.
On the other hand, status-quo also refers to the herd-mentality and following the crowd. Since it is much more difficult to be a contrarian than it is to agree with consensus, investors can sometimes mistakenly follow the crowd. Some of the stock market bubbles and crashes can be partially explained by the status-quo bias. In an asset bubble, the majority of investors (and capital) follows the crowd despite the fact that asset prices are decoupled with economic fundamentals. But then again, there is the popular wisdom of the crowd.
The key for individual investors is to think independently. Assessing whether the crowd is rational or not, and being willing to take a contrarian position when the crowd is irrational, are fundamental attributes that can help investors not to fall in the status-quo. When crowds are right, follow them. When they are likely to be wrong, don't follow them. But the important thing is that the decision is made by one self.
In a paper published in the Journal of Risk and Uncertainty, psychologists revealed a strong presence of status-quo in human decision-making process. When presented with different investment options (like bonds and stocks), individuals in the study were largely biased by a status quo that was invented by the researchers. For example, individuals were presented an inherited portfolio for which they could have made a smarter capital allocation, but most preferred to maintain the status quo. That is, they maintained the initial portfolio that had a lower expected return.
I recommend interested readers to take a look at the sample questions and full results of the experiments. It's interesting.
Unlike a calculation error, the status-quo bias is difficult to perceive because it is mainly done by intuition. The psychologists report that people were actually surprised by the presence of status-quo in their decision making process. Status-quo decisions can be made because they are convenient, easy, habitual or due to inertia. Status-quo is very difficult to overcome. The best approach to avoiding a fall in the status quo is through education and avoid complacency. The key is to balance out complacency and over reaction.
Regret-aversion bias - avoiding responsibility
It refers to the idea that investors fail to make decisions or take action because of the fear that they will regret it the future. This bias is closely tied to errors of omission, where an error is made because no action was taken. Warren Buffett claims that some of his biggest mistakes in investments were errors of omission. The simplest explanation for this bias is that no one wants to be responsible for bad decisions.
Harry Markowitz, a Nobel Prize winner, has expressed regret-aversion bias by allocating 50% of his investments to bonds and 50% to stocks. He backed this allocation by saying:
"I visualized my grief if the stock market went way up and I wasn't on it - or it went way down and I was completely in it. My intention was to minimize my future regret."
Regret aversion can be costly to investors. On one side, investors might avoid the stock market after seeing a sharp decline (as it is happening the first weeks of 2016). In reality, when the fundamentals of a company are very strong, depressed stock prices are less risky than high stock prices. On the other hand, investor might hang onto a stock with poor fundamentals because of the regret of missing out on the recovery.
In a research about the behavior of institutional investors in the Tehran Stock Exchange, regret aversion was found responsible for both the avoidance of selling losing stock and quickly selling fundamentally solid stocks. The former was probably due to fear of missing out in the recovery. The latter was probably due to fear of seeing their gains disappear after a market downturn.
The first step is to be aware of the natural regret-aversion behavior and be willing to take responsibility. Being aware of the bias is key. The next step is to quantify risk and return prospects. By performing fundamental research, or buying research from reliable sources, investors can avoid making uninformed decisions. Either avoiding selling a stock too quickly or hold onto sure losers, the time and money spent can be well worth it when investing for retirement.
Lastly, in order to avoid selling quickly a potential winner, or in order to avoid holding onto to losers, it is good to have a game plan. One way to having a game plan is to build fundamental analysis under different scenarios. As the famous investor Peter Lynch said: "Know what you own, and why you own it"
By controlling what one can control, investors can set their minds to be tougher in the chaotic environment of the stock market. Both falling into a comfort zone and avoiding decision making can be hurtful in the long-run.
For one thing, a comfort zone might lead to not being willing to challenge the status quo. Not all status quo should be challenged, but sometimes they have to be. The first step to challenge the status quo is to be willing to do it.
On the other hand, regret aversion bias can cause one to sell a winner too quickly, or hold onto a loser for no reason. The important thing is to be willing to take responsibility, and be fearless to take action when action is needed.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.