Investors act differently when they are scared. Most of us don’t like to admit that emotions can control our actions, however, neuroscience tells us a different story.
Evidence shows that emotions can play a large role in decision-making and can, at times, lead to choices that are not in our best interests.
The recent stock market roller coaster ride is a good example. The volatilely was the result of the Brexit vote in the UK that showed a majority of Britons wanted to leave the European Union.
Investor reaction to the Brexit vote was normal.
To put things in proper perspective, we should consider the economic logic of how people make investment decisions.
The first component is determining the value of a stock.
Investors predict the future cash flow from a stock and, based on the future stream of cash flow, they determine the price they are willing to pay to purchase it. That is the logical process and it is simply a case of adding up the numbers.
The second component is for investors to evaluate their own sensitivity to risk. If they purchase a riskier stock they will expect a higher return on investment for taking that additional risk.
Millions of investors use these two components to determine the price they are willing to pay for a specific stock and it works on a fairly predictable basis.
That is, until the world unravels and fear sets in.
The aftershock of the Brexit vote has had, and will have, many ripple effects. Investors are nervous, some are scared.
Fear can exacerbate ‘herd behaviour’, which is one reason why, during periods of investor fear, volatility increases.
Some may wonder why markets can be relatively calm most of the time and yet so surprisingly and unexpectedly volatile other times.
The lesson we can learn from the Brexit vote and other similar periods of fear is: increased volatility is normal.
Simply put, that is how the stock market works.
How you react to periods of volatility will be one of the single most important factors affecting your ultimate investing success.
Most of us humans get it wrong.
There are two reactions to fear of market conditions that cause investors great harm.
The first is to sell an investment and leave your money in cash.
Investing in stocks is a long-term process and selling at a loss just because you are scared makes no sense. Investors inclined to do this are better advised no to own stocks.
The second is to try to capitalize on a changing market by buying and selling stocks on a short-term basis.
Evidence suggests this is extremely harmful for investors as there is far more risk at speculation in the short-term than a logical long-term strategy of investing.
My recommendation is to invest in stocks for the long-term and do not be tempted to adjust this strategy as a result of short-term events. Short-term events are normal so they should be taken in stride.
Stocks have specific financial characteristics, but they are owned by humans.
Human behaviour during periods of uncertainty is volatile.
It is in your best interests to try and control your emotional behaviour and focus on your long-term investment objectives.