Diving into fundamentally bearish market territory, Wall Street is struggling to find an anchor point to allow it to reverse the trend. In the absence of benchmarks, the sessions remain volatile, oscillating between emotion and fear. Small return on the behavioral finance and the rationality of the basic principles as regards investment.
From January’s peak to trough, the S&P 500 is down 25%. Wall Street’s benchmark index has since recovered somewhat, narrowing its decline to 18%. But the context of uncertainty persists. By shifting their attention from the inflationary slippage to the risk of a recession, stock market investors are currently stopping at the statistics indicating a deceleration in economic activity and are struggling to find the right slowdown to allow the American Federal Reserve (Fed) to reduce its “aggressiveness” in order to avoid recession.
Despite this great volatility, the basic principles of investment retain all their relevance. They are, however, shaken to their foundation by the surrounding unknown. Drawing inspiration from a text published in May by RBC Global Asset Management, one of them tells us that diversification remains one of the best ways to manage portfolio volatility. However, the problem in the current bear market is this correlation that has become positive between equities and bonds.
Another principle calls for long-term investing, not “playing” the market. But here we are confronted with different branches of neuroeconomics, including behavioral finance and prospect theory, which looks at decision-making in a world of risk. This shows in particular the reluctance to give up something present, with people placing less value on a future reward than on an immediate benefit. They find it difficult to make sacrifices now for a future that seems uncertain to them.
Also, the more you check the value of your portfolio, the more volatile it seems.
We also note that in the past, the markets have always regained strength and displayed a long-term upward trend. In the RBC document, it is shown that $10,000 invested since January 2001 was worth $44,505 at the end of 2021, according to the S&P/TSX index, this, without fees and taxes. Or that the Toronto index return range of 1er January 1980 to December 31, 2018 varied between +64% and -25% over a period of one year, between +32% and -8% over a period of three years, between +28% and -2% over five years , and between +18% and +1% over a period of ten years. In short, time reduces the effects of volatility. Which still brings us back to the memory of the lost decade for investors, that of 2000-2010, during which the American S&P 500 index posted the first negative return over ten years in its history.
Finally, the investor is urged to focus on what one can control, which includes controlling emotions. “Over the long term, investing success is less about how the markets fluctuate and more about how you react to that volatility,” it reads.
Five behavioral biases
RBC Global Asset Management accompanies this invitation with a list of five common behavioral biases:
Anchoring. Fixing on a specific point of reference, such as the purchase price of an investment or the level of a market index, on which decisions are based. “It can induce investors to overvalue or undervalue asset prices or market returns, based on an arbitrary number drawn from past experience. »
Aversion to risk. The feeling caused by a loss is much more intense than the satisfaction drawn from a gain of an equivalent amount. The investor would prioritize avoiding short-term losses to the detriment of long-term gains.
Recency. Consists of giving too much importance to the most recent experiences in memory, even if they are not the most relevant or the most reliable, explains the financial institution.
Familiarity. The investor prefers to invest in what he knows well. “This can increase portfolio risk and lead to a more uneven investment experience. »
Confirmation. Limit yourself to seeking or accepting information that supports what you believe. Ignoring information that contradicts decisions made can lead to unrealistic expectations and result in portfolio concentration and increased risk.
And RBC reminds us of this truth that it is easy to be comfortable with a higher level of risk when the markets are bullish, only to become disillusioned when they are bearish. Behavioral finance teaches us that the prospect of a loss can cause an investor twice as much pain as the satisfaction of the same gain.