Behavioral Finance

Your Chief Enemy Today Is Likely Yourself

Volatile swings like those that followed Thursday night's Brexit vote aren't a call to action. They are a call for reason.

Maybe you love European politics, and understand Thursday's Brexit vote inside and out. Maybe you don't know anything about it and figure the Queen still runs the show. Perhaps you're really old school and figure Oliver Cromwell is in charge. No matter. This morning you are awaking to scary headlines and sharply swinging markets tied to last night's UK vote to leave the European Union. (If you want to learn the specifics and what it means and doesn't mean, click here.) These swings might be triggering strong "SELL" signals in your gut. Maybe it even feels queasy or in knots. Those feelings are natural! But acting on such urges is perilous. Now, during a time of massive volatility, isn't a time to trade-it's time for introspection.

Humans are hard wired with the fight-or-flight urge-the uneasy feeling you must "do something" to try to avoid danger. In markets, that urge arises during volatility because of prospect theory (also known as myopic loss aversion). Prospect theory holds that investors feel the pangs of loss more than twice as much as they appreciate an equivalent gain. Then, when fear rises, you get that shot of adrenaline coursing through your bloodstream. Now you think not only that you must do something, but you must do something NOW. This is what's making you feel uneasy, and driving the urge to take action.

As I wrote to readers five years ago in the hellaciously volatile moments after the US's credit rating was downgraded amid an acrimonious debt ceiling fight, that urge is not your friend. It is, in my opinion, why legendary investor Benjamin Graham once wrote that, "The investor's chief problem-even his worst enemy-is likely to be himself." For long-term investors, controlling emotion and keeping an even keel at times like the present is crucial. With that in mind, here is the strategy I laid out to conquer volatility five years ago, when I gave you my grandfather Dex's classic-if-redundant advice: "Desperate people do desperate things." It is apropos today, too:

  • When stocks fall sharply and your gut kicks in, don't immediately jump online or get on the phone. Turn off the news. Stop. Take a deep breath. Do something not related to investing. Essentially, disconnect to lower your blood pressure.
  • Put market movement in its proper context. If you're in relatively good health and have a reasonably long life expectancy, you should be planning for decades ahead-not minutes, hours, days or weeks.
  • Ask yourself the question: Am I seeing the full picture of market and economic conditions? Balance the fear and be a skeptical consumer of media.
  • Seek out opinions of others-especially those who might disagree with what your gut says. This is all targeted at avoiding confirmation bias. The last thing you need is a "yes man" when you're in a heightened emotional state.

    Perhaps most important: Consider major asset allocation shifts very coolly and rationally. Nobel-prize winning studies have shown asset allocation is the most important decision you make in investing-meaning it must be made with a clear mind, not one encumbered by emotion.

None of this is to say that today, now, is the exact same as five years ago. The debt ceiling and a credit rating move aren't the same as Brexit-the specifics vary greatly. All I'm suggesting is the animalistic action-fight or flight-urge we have is often wrong in investing, and may lead you to actions you would otherwise never consider. Trading when volatility is high and stocks are low-like now-is a classic behavioral error. Your gut tells you that you're saving yourself from loss. Later, the reality sets in: By selling when markets swing wildly, you are locking in the losses already incurred-at the most emotional moment in time. And you are ensuring you'll have to make another decision, which isn't assured to be correct, to recoup them.

Decisions, you see, are the problem. Investing is all about decisions. Business decisions. When you own stocks, you own slices of businesses' future profits. Emotions and gut instincts are poor tools to break down the balance sheet of a major publicly traded company. They are equally ill-equipped to assess complex systems like markets and the economy. You must employ cool, rational logic, and assess markets' forward-looking fundamentals free of bias. I am not aware of any well-regarded investment legend who earned their status by assessing balance sheets while panic-stricken.

Look, there are valid reasons and times when selling stocks and taking a defensive posture is warranted. But those times are rare, and doing so really makes sense only if you have a rational, sound reason to believe significant downside ahead is the most likely outcome. Not "more downside is possible." Not "maybe there is more." Only "very likely more." Successful equity investing generally requires you to be in equities vastly more often than not.

You can't control markets. You can only control you, and the decisions you make. Focus now, today, on not letting your emotions-those urges we all struggle to control-take you over. Don't let the most irrational, reactive parts of our chemical and psychological makeup guide your actions. Chief among humans' defining features is our reason. Now is a time to employ just that and avoid reacting emotionally to markets.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.