The psychology of stock market cycles

When the lows of market downturns follow the highs of strong equity performance, some clients may struggle to see volatility as simply part of a larger stock market cycle. Investors reacting to a falling market can themselves fall into psychological traps that can keep them from acting rationally. You can help clients overcome these traps by showing them how the market cycle typically progresses and how it can be leveraged.

Mental tricks

You don’t have to be an armchair psychologist to help clients understand how behavioral impulses and emotions can turn rational investors into irrational ones. A review of essential behavioral finance concepts readily turns up common traps, triggers, and misconceptions1 you may pick up in clients, particularly during volatile periods. These include:

  • loss aversion – when investors expect high returns but low risk
  • narrow framing – making decisions without considering implications
  • anchoring – relating to familiar, if inappropriate, experiences
  • herding – copying the behavior of others even when outcomes are unfavorable.

Talking behavioral finance

One way to help clients is to make them aware of these traps. Discuss how this form of behavioral economics can potentially lead to poor decisions such as buying and selling at the wrong time.

Behavioral economics and associated theories of how investors act under various scenarios have been widely studied. One economic theory stands out as the basis of behavioral finance – the prospect theory. In this theory of choosing between risky prospects, investors can fall into the trap of pseudo certainty – when markets are positive, investors tend to be risk averse, but they tend to seek more and more risk as markets go down. If that seems counterintuitive, look at this example.2 Investors polled were given this choice:

A: Winning $6,000 at a 45% probability

B: Winning $3,000 at a 90% probability

Most respondents (86%) chose B. But a majority of those same people (73%) chose C, the less probable option in the choice below.

C: Winning $6,000 at a 0.10% probability

D: Winning $3,000 at a 0.20% probability

A completely rational decision would involve choosing the option with the higher probability (D), no matter how small. But this is a good reminder that investors are people, and often make judgments based on their own assessments and biases.

What the prospect theory also suggests is that the value of money can change for people depending on gains and losses – they can have different emotional reactions. Investors may be more stressed by prospective losses than happy about positive returns. It explains why you don’t necessarily hear anything about a $500,000 portfolio gain, but are likely to get a call from an upset client about a $500,000 loss.

Prospect theory, and the notion of taking more risks to avoid losses than to realize gains, also explains why investors hold onto losing stocks. Many investors want to remain in a risky stock position, hoping the price will bounce back and falling into the trap of trying to win it all back.

Investor emotions during market cycles

Investor sentiment during market cycles graph

Source: Investorz Blog

Past performance is not indicative of future results.

Charts are for illustrative purposes only, not meant to predict actual results, and are not representative of the performance of any specific investment.

Applying models to market cycles

As an advisor, you can help clients understand not only the psychological traps but how they can apply to the stock market cycle, as seen in the graphic [above]. Trigger the discussion by asking your client whether they’ve experienced emotions such as fear or panic when they see the market taking a sharp downturn. By talking through the psychology behind this emotional roller coaster, you can help them find practical ways to counteract the traps. Some discussion points include:

  • The cycle has repeated historically. Discuss how past market cycles followed similar patterns of peaks and troughs, which can serve to calm those unnerved by sharp downturns.
  • Reinforce how emotions such as greed or fear tend toward extremes at the high and low points of the cycle, and how this shows why so many people are compelled to buy at market tops and sell at market bottoms.
  • Demonstrate that the danger point in market cycles is, counterintuitively, when the market is most euphoric – and the lowest point can represent the most opportunity.
  • Talk through how, as the market cycle slides to the low point, mental traps can also account for why investors may resort to taking on more and unwarranted risk.
  • At the stage when panic gives way to capitulation and then the low point of the cycle, help investors recognize this as an opportunity to look at investing possibilities as the cycle starts to climb back to optimism.

How to navigate emotional investing

How can you help clients navigate volatile markets while keeping an even keel? One key is to help them understand the motivations behind emotional investing and to avoid the investment traps that can lead to poor decision-making. Help steer clients on the path of rational investing by avoiding:

  • overconfidence
  • loss aversion
  • chasing past performance and market timing.

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1Dalbar, Inc., Quantitative Analysis of Investor Behavior, 2015 edition.

2Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," 1979.

The views expressed represent the investment team’s assessment of the market environment as of May 2020, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Diversification may not protect against market risk.

Market risk is the risk that all or a majority of the securities in a certain market – like the stock market or bond market – will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.

All charts are for illustrative purposes only. Charts have been prepared by Macquarie Investment Management unless otherwise noted.