Beginner’s Guide to Market Volatility

'People tend to sell winners and hold losers': 3 bad moves investors make when markets are volatile

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Key Points
  • "Technically we're not in a bear market, but the average investor is in a bear market," says Ryan Detrick, chief market strategist for LPL Financial.
  • If you hold individual stocks or cryptocurrencies that have suffered big losses, you may be reluctant to sell due to cognitive biases, say behavioral finance experts.

As it stands, the broad stock market hasn't entered bear territory, defined as a 20% decline from recent highs. As of midday Tuesday, the S&P 500 was trading 18.5% below its January peak. But that doesn't mean you aren't experiencing your own personal version, especially if you own individual stocks or cryptocurrency.

"Technically we're not in a bear market, but the average investor is in a bear market," says Ryan Detrick, chief market strategist for LPL Financial. "The median stock is down 25%. Half the stocks in the Nasdaq have been cut in half. Investors feel like it's a bear if they look at their portfolios."

If you've made some speculative bets in your portfolio that look like losers lately, your situation may get worse. That's because you may be prone to unconscious biases that guide your choices around your individual investments that could hurt your portfolio further, say behavioral finance experts.

"All of these investor biases tend to run into each other, but when markets get really volatile, some of them really stand out," says Scott Nations, president of investment volatility analytics firm NationsShares and author of "The Anxious Investor." 

Here are three bad behaviors that experts say are particularly prevalent among retail investors who are invested in riskier assets.

How cognitive biases can make investing in risky assets worse

Market experts tend to draw a distinction between investing and speculating. Investors typically spread their bets among a wide variety of assets in the hopes of earning compounding annual gains and building wealth for the long term. Traders or speculators hope to capitalize on the volatility of certain assets to make quicker, short-term profits.

When it comes to building your portfolio, there is room for both mindsets. But if too much of your money is tied up in highly risky assets, you stand the chance of incurring big short-term losses — losses which could escalate if you're not aware of some of the most common cognitive biases:

Loss aversion

This bias describes an asymmetry in human emotion when it comes to wins and losses. In short, people hate losing much more than they love winning.

"It's something that everyone experiences, especially if you've taken it on the chin and your ego is being bruised around your investment decisions," says Brad Klontz, a financial psychologist and professor at Creighton University.

You may know in your head that an investment is a loser, but until you sell, the loss isn't official, and you still have a chance to bounce back. "We've seen this in some of the speculative crypto coins," says Klontz, who is also a certified financial planner. "People want to maintain pride by not selling. Some of these things are down 99%, and people have ridden them all the way to the ground."

Anchoring

If you paid a certain amount for something, that tends to be what you think it's worth. The problem is, this thinking persists, even when the value of the asset you bought materially changes.

"If you bought something for X, and now it's down 20%, it's tough to disabuse yourself of the notion that it's really still worth X," says Nations.

Once you get locked in on that number, it can be difficult to sell an investment, even if it has fundamental flaws, says Klontz: "You think, 'Once it gets back to what it's worth, I'll sell it.' And that may never happen."

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Disposition effect

Investors, like everyone else, like to feel smart. So when a stock they own goes up, they tend to sell and take the profits. When a stock goes down, they tend to hang on and wait for a rebound. In other words, "people tend to sell winners and hold losers," says Nations.

This effect is potentially amplified on social media, Nations adds, with influencers who have touted losing investments continuing to flog them rather than accepting the shame of admitting that they made a bad call.

How to overcome investing biases

Holding onto investments when they're down can be good under the right circumstances — specifically, if you have a core portfolio of diversified investments. "If you're a diversified long-term investor, short-term losses don't really matter, and sticking to the plan is a great mindset," says Klontz. "But that thinking will come back to bite you if you're engaged in a highly speculative trading strategy. You won't accept the fact that you've made a very bad decision."

If you find yourself having suffered losses in portions of your portfolio, take a moment to reassess your decisions. If you were using some of your money to invest in individual stocks, re-examine your reasoning behind your investment in the first place while examining the company's fundamentals.

If your long-term outlook for the company is unchanged, you could be right to hold on. But question whether you're holding on because you want to get back to breakeven, says Nations. "Sell a third of it and see if that helps you think a little more clearly," he says. "If it does, you may realize that you have a lot of biases at work."

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Many investors hold their riskier bets in a so-called "satellite" portfolio that complements their core holdings. Wise portfolio-builders generally avoid allocating more money to these investments than they're willing to lose, experts say. Given the recent downtrend, it could be time to re-evaluate how much risk you're comfortable taking, even among your bigger gambles, say Klontz.

"Maybe you've learned your lesson, and you think you should go ahead and put that money in your core portfolio," he says. "If that's your betting pot, think about what actually happens when you go to Vegas. You have fun. It's exciting. And then you kind of slink out the casino with some feelings of regret and remorse."

After years of gains among speculative investments, a reality check might not be such a bad thing, he adds. "This kind of strategy is meant to be your fun money, and we all wish you well," he says. "Just try not to rob from your other fund."

The views expressed are generalized and may not be appropriate for all investors. The information contained in this article should not be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Carefully consider your financial situation, including investment objective, time horizon, risk tolerance, and fees prior to making any investment decisions. No level of diversification or asset allocation can ensure profits or guarantee against losses.

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