Investing

Behavioral finance expert: Why investors tend to ‘behave irrationally’ when stock prices fall

"Investors are prone to panic when they think things may be headed further south."

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When stock and cryptocurrency prices fell earlier this week, you may have seen some advice popping up in your social media feeds in the form of an initialism: BTFD.

For the uninitiated, that stands for buy the, ahem, dip. In theory, it's solid investing advice for holders of digital coins and shares of stock alike. By adding more shares of an investment after it's declined, you're effectively buying it on sale and potentially boosting your returns over the long run.

"Any investor with time — multiple decades — should use each and every correction as a buying opportunity," Jamie Cox, managing partner at Harris Financial Group, recently told Grow.

There's only one problem: Most investors have trouble following through. Although they're theoretically on board with the idea, "people tend to behave irrationally," says Mahesh Kashyap, co-founder of Kievanos, an investment research firm focused on behavioral finance. 

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"When human behavior kicks in, people are actually selling when markets are dropping off and then trying to get back in when investments rally," he says.

In other words, people often sell low and buy high. This behavior, which can damage your portfolio over the long run, comes down to a couple of prominent investor biases, experts say.

Two biases that hold investors back

Mark Gorzycki, Kashyap's partner at Kievanos, says that investors tend to do the opposite of what they intend because of two cognitive biases: loss aversion and herd mentality.

1. Loss aversion

Investors are much more sensitive to the downward movements in an investment's price than the upward ones. "The perception of a loss can be exponential, whereas the perception of a gain is linear," Gorzycki says. "If I bet you $100 on a coin toss, and you lose, you're going to feel it much more significantly than if you'd won, even though you have a 50/50 chance."

As a result of this bias, he adds, investors are prone to panic and sell declining investments when they think things may be headed further south.

2. Herd mentality

When prices start to bounce back, investors want to get in with the crowd that's making money.

"It's almost a fear response. You think, 'I better lock this in. I better secure the return I have in front of me,'" Gorzycki says. In other words, investors often get FOMO when it comes to investments that have gone up, so they buy in at a higher price than might be ideal.

If I bet you $100 on a coin toss, and you lose, you're going to feel it much more significantly than if you'd won.
Mark Gorzycki
Co-founder, Kievanos

How to buy low and sell high

Once you understand where your investor biases are coming from, experts say that you can employ strategies to ensure that you're buying low and selling high, rather than buying or selling based on emotional responses to market moves.

One solution is dollar-cost averaging, or investing a set amount of money into your portfolio at fixed intervals, rather than trying to time moves in the market. By doing so, you'll end up buying more shares when prices are low and fewer when prices are high.

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Another move that can help take emotions out of the equation: setting price targets for holdings in your portfolio. Rather than wondering if an investment has gone down enough for you to buy more, or trying to hop in when you see it start to tick up from what you think is a bottom, pre-determine at what prices you'd be comfortable buying and selling. "No matter what kind of investor you are, you need to look at the fundamentals and have a plan for when you want to get in and when you want to get out," says Sam Stovall, chief investment strategist at CFRA.

Once you have price targets in mind, you could use your brokerage website to set price alerts on your investments. If something you own falls below your target price, you would get an alert signaling you to buy, even if it means going against the grain.

That's often a good strategy anyway since, when it comes to the markets, "you want to be a buyer when there are net sellers," says Gorzycki. "You want to buy when there's blood in the streets."

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