It’s always important to maintain a long-term perspective, but especially when markets are declining. Although stocks rise and fall in the short term, they have tended to reward investors over longer periods of time. May was a tough month for the stock market and it’s natural for emotions to bubble up during periods of volatility. You wouldn’t be human if you didn’t fear loss.
Nobel Prize-winning psychologist Daniel Kahneman demonstrated this with his loss aversion theory, showing that people feel the pain of losing money more than they enjoy gains. Thus, investors’ natural instinct is to flee the market when it starts to plummet, just as greed prompts people to jump back in when stocks are skyrocketing. Both can have negative impacts.
But smart investing can overcome the power of emotion by focusing on relevant research, solid data, and proven strategies. Here are three principles that can help fight the urge to make emotional decisions in times of market turmoil.
Market Declines Are Part of Investing
Stocks have risen steadily for a decade, but history tells us that stock market declines are an inevitable part of investing. The good news is that corrections (defined as a 10% or more decline), bear markets (an extended 20% or more decline) and other challenging patches haven’t lasted forever.
The Standard & Poor’s 500 Composite Index has typically dipped at least 10% about once a year, and 20% or more about every four years, according to data from 1949 to 2018. While past results are not predictive of future results, each downturn has been followed by a recovery and a new market high.
Markets Tend to Reward Long-Term Investors
No one can accurately predict short-term market moves, and investors who sit on the sidelines risk losing out on periods of meaningful price appreciation that follow downturns.
Every S&P 500 decline of 15% or more, from 1929 through 2018, has been followed by a recovery. The average return in the first year after each of these declines was nearly 55%.
Emotional investing can be hazardous.
Kahneman won his Nobel Prize in 2002 for his work in behavioral economics, a field that investigates how individuals make financial decisions. A key finding of behavioral economists is that people often act irrationally when making such choices.
Emotional reactions to market events are perfectly normal. Investors should expect to feel nervous when markets decline, but it’s the actions taken during such periods that can mean the difference between investment success and shortfall.