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Hardwired to React: Why Investors Make Mistakes That Could Have Been Avoided

June 4, 2020 

How to Help Prevent Your Inner Alarm System From Hurting Your Investment Results

Financial Advisors: This article is based on our popular Media Replay module. Click here to access additional content to share.

Functions of the Reactive and Reflective Parts of Our Brains

snake

Reactive Brain

  • Avoid danger or loss
  • Can shut down reflective brain
  • Emotional responses
squareRoot

Reflective Brain

  • Complex decisions
  • Rational
  • Analytical

Remaining calm is a Navy Seal’s key to success. Yes, they endure extreme combat training. But during a mission, all that training would be useless if they couldn’t control their emotions. To remain calm, they use “box breathing.” You can try it by breathing in for four seconds, holding your breath for four seconds, exhaling for four seconds, and holding your lungs empty for four seconds. Repeat it a few times. In the most stressful situations, box breathing helps Seals remain calm.1

Similarly, investors need to remain calm when market volatility strikes, but it can be difficult to control our emotions. When we fear losing money or missing out on gains, emotions can influence our decision-making ability. Like the Seals, we need a way to control our emotions to avoid making decisions that could hurt our long-term results.

 

In This Article You’ll Learn:

  1. Two parts of our brain with different objectives
  2. When our reactive brain takes over
  3. How we resist our reactive brain when the market drops

 

1. Two Parts of Our Brain With Different Objectives

Imagine you’re taking a relaxing walk down a trail. Suddenly, a snake slithers on the path in front of you. Do you start trying to determine what kind of snake it is, or whether or not it’s poisonous? Probably not. Most of us, with the exception of snake enthusiasts, automatically stop, jump back, and start walking backwards. This type of response is caused by what neuroscientists call our reactive brain. It’s the part of our brain that helps us avoid danger or loss.2 With investing, it reacts when we’re afraid of losing money. It can also react with excitement when we have a big gain or worry if we’re afraid of missing one. For example, our reactive brain is activated when people in the office pool their money together to buy a lottery ticket. Our reactive brain wants us to participate so we don’t miss out on a windfall.

Another part of our brain is what’s called the reflective brain. It performs complex decision-making and planning, e.g. solving a calculus problem, or following a recipe. How the reactive and reflective parts of our brain work together can have significant effects on our investment results.

 

2. When Our Reactive Brain Takes Over

We like to think of ourselves as rational decision-makers when it comes to investing. We envision ourselves building a long-term plan, with a diversified portfolio of stocks, bonds, and cash investments —and sticking with it. But sometimes, market volatility can influence our rational outlook, such as an 1,000- or 2,000-point drop or rise in the Dow (See Figure 1). Many things can drive volatility, such as trade deals, national debt, interest rates, and more recently, a pandemic. Dramatic headlines often follow, proclaiming either soaring or plunging markets, which can cause our rational mindset to go haywire.2

Sometimes, those big point drops turn into bear markets (typically defined as a 20% market drop). Since WWII, there have been 13 bear markets—one about every 5.7 years.3 When they happen, do you think to yourself, “Oh, that’s just another bear market. I’m a long-term investor, so I’m not going to give in to fear by changing my portfolio”? Possibly.

But often a bear market can cause a different reaction—one that causes investors to question their investment plans. News about market drops can trigger our reactive brain in about 12 milliseconds.2 Because its function is to help us avoid danger and loss, our reactive brain can tempt us to change our portfolio to avert losing more money.

 

Figure 1. Big Drops and Rises Activate Our Reactive Brains

The Dow’s Largest Point Losses and Gains

Largest Daily Point Gains
3/24/2020 2,112.98
3/13/2020 1,985.00
4/6/2020 1,627.46
3/26/2020 1,351.62
3/2/2020 1,293.97
Largest Daily Point Losses
3/16/2020 -2,997.10
3/12/2020 -2,352.60
3/9/2020 -2,013.76
6/11/20 -1,861.82
3/11/2020
-1,464.95

When our reactive brain responds to large drops or rises, we can be tempted to change our portfolios.

Past performance does not guarantee future results. Investors cannot directly invest in an index.

Source: Sizzlers and Fizzlers, Indexology, 2020

 

But What About Our Reflective Brain?

Can’t our more rational reflective brain counter the emotional response of the reactive brain? Unlike the reactive brains 12-millisecond response speed, the reflective brain takes 40 milliseconds for the market-drop news to reach it—more than three times longer.2 By that time, our reactive brain may have already taken control of our decision-making, essentially shutting down the reflective brain’s more rational perspective.2

 

Figure 2: Individual Investors Have Underperformed Market Indices

Average Annual Returns for the 30 Year Period Ending 12/31/2019

DalbarChart

Source: Quanitative Analysis of Investor Behavior, Dalbar, 2020

Past performance does not guarantee future results. Performance data for indices represents a lump sum investment in January 1990 to December 2019 with no withdrawals. Stocks are represented by the S&P 500 Index. Bonds are represented by the Bloomberg Barclays US Aggregate Bond Index. Indices are unmanaged, unavailable for direct investment, and do not reflect fees, expenses, or sales charges.

Unmanaged index returns do not reflect any fees, expenses, or sales charges. Index performance is not indicative of any Hartford fund.

 

When Our Reactive Brain Takes Over, We’re More Likely to Make Decisions That Could Hurt Long-Term Results

We may be more apt to choose safer investments during market volatility. As a result, we could miss recoveries. Alternatively, after a series of upward market moves, we may choose more aggressive investments, then experience significant losses if the market drops again. Over time, these kinds of reactive decisions tend to reduce the returns of individual investors.

Dalbar’s Quantitative Analysis of Investor Behavior demonstrates that emotions can get the best of investors when it comes to decision-making. Over the past 30 years, based on average annual returns, the average equity investor underperformed the market each year by an average of 4.92%. The market returned 9.96%, while the average equity investor’s return was 5.04% (See Figure 2).

The reactive brain’s influence can reduce investment results. According to the Dalbar report, “...it’s the psychological traps, triggers, and misconceptions that cause investors to act irrationally. That irrationality leads to buying and selling at the wrong time, which can lead to underperformance.”

 

3. How We Can Resist Our Reactive Brain When the Market Drops

There’s plenty of information online to help you build a portfolio yourself. There are also online services that will do it for you. These options may be cheaper than hiring a financial advisor, but building a portfolio is only one aspect of investing.

How you manage that portfolio over time will affect your long-term results. Will you be able to control your emotions when your reactive brain wants to take over during market volatility? There are resources that can teach investors how to remain calm and make rational investment decisions. However, many investors may not have the time or motivation to learn these techniques. And even if they did, it doesn’t guarantee that they won’t make mistakes in a market meltdown.

A financial advisor can help you manage your emotions and decision-making when your reactive brain tries to take over. They’ve seen bear markets come and go. They know how to weather the storm when markets get rough. On the surface, hiring an advisor will cost you more than managing your portfolio yourself. Many advisors charge a percentage of an investor’s balance, typically about 1% a year.4

But that 1% fee may be worth it, especially if an advisor could help you avoid the types of mistakes that caused to the individual investor to underperform the market by 4.92%.2

 

“But Even With a Financial Advisor, I Still Can’t Stand Losing Money”

A financial advisor could help you avoid emotion-based investment decisions. But ultimately, you’re in control of your decisions. At any time, you can tell your advisor that you can’t take any more market volatility and want to change your portfolio. The advisor will honor your decision. So if you choose to work with an advisor, you’ll have to decide if you’re going to trust their advice when volatility strikes.

 

Remember 3 Things About Decision-Making During Periods of Market Volatility

First, realize that your brain has two parts that are involved with decision making, the reactive and reflective systems. Second, when volatility strikes, your reactive brain can overpower and even shut down your reflective brain. When the reactive brain takes over, you can be apt to make emotionally-based decisions. Third, a financial advisor could help you avoid emotionally-based investment mistakes.

 

Sticking to a Plan Can Be Difficult

If you look at a 50-year investment history, showing the trends of stocks, bonds, and cash investments, achieving investment success appears pretty simple (See Figure 3). Stocks had more volatility, but they outperformed bonds and cash. That’s why many investors build a portfolio over-weighted in stocks, and stick with it for the long-term.

But sticking with that plan isn’t easy. Remaining calm under stress, like a Navy Seal, can be extremely difficult, especially during times of volatility. During bear markets our reactive brain can take control and tempt us to change our plan to minimize losses. A financial advisor can help you resist these urges and keep your plan in place.

 

Figure 3: Individual Investors Have Underperformed Market Indices

Average Annual Returns for the 30 Year Period Ending 12/31/2019

CCWP077_1edit

 

When the market drops 30%, it’s possible for our reactive brain to influence decision making. We can be tempted to make our portfolio safer, like the Reactionary Investor did in the graph above. Historically, those panicked decisions hurt investment returns.

 

Past performance does not guarantee future results. Equity returns are represented by the S&P 500 Index. Bond returns are represented by the Bloomberg Barclays Long-Term US Treasury Total Return Index. Reactionary returns indicate the results of an investor who invested in S&P 500 Index, moved 100% into 90-Day T-Bills each time the market dropped 30% and then moved 100% back into S&P 500 Index two years later. Balanced returns are represented by 50% S&P 500 Index and 50% Bloomberg Barclays Long-Term US Treasury Total Return Index. Cash returns are represented by 90-Day T-Bills.

Data Source: Ned Davis Research, 12/19. For illustrative purposes only. Indices are unmanaged and not available for direct investment.

 

 

Next Steps

  1. Download the Media Replay brochure below
  2. Reflect on past periods of market volatility, e.g. The Great Recession of 2007-2009, or when the market dropped nearly 20% in December 2018, or the bear market of 2000-2002. Think about how you responded. Were you tempted to change your portfolio? Did you?
  3. Email this article or share it on Facebook, LinkedIn, or Twitter


Dalbar’s Quantitative Analysis of Investor Behavior Methodology - Dalbar’s Quantitative Analysis of Investor Behavior uses data from the Investment Company Institute (ICI), Standard & Poor’s, and Barclays Index Products to compare mutual fund investor returns to an appropriate set of benchmarks. Covering the period from January 1, 1990 to December 31, 2019, the study utilizes mutual fund sales, redemptions and exchanges each month as the measure of investor behavior. These behaviors reflect the “average investor.” Based on this behavior, the analysis calculates the “average investor return” for various periods. These results are then compared to the returns of respective indices.

Average equity investor and average bond investor performance results are calculated using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions, and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses, and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: total investor return rate and annualized investor return rate. Total investor return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions, and exchanges for each period.

 

Sources:

1“How To De-Stress In 5 Minutes Or Less, According To A Navy SEAL,” Forbes, 5/30/19

2Lennick, Doug. Financial intelligence, FPA Press, 4/21/2010. Most recent data available.

3Ned Davis Research, 1/20

4“How Much Does a Financial Advisor Cost?” US News and World Report, 12/31/18

Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, event and interest-rate risk. As interest rates rise, bond prices generally fall. •Diversification does not ensure a profit or protect against a loss in declining market.

This information should not be considered investment advice or a recommendation to buy/sell any security. In addition, it does not take into account the specific investment objectives, tax and financial condition of any specific person. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice.

Index Descriptions

Indices are unmanaged, and unavailable for direct investment, and do not represent the performance of any Hartford Funds.

Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.

S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.

Bloomberg Barclays US Aggregate Bond Index is composed of securities from the Bloomberg Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.

Bloomberg Barclays US Long Treasury Total Return Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with 10 years or more to maturity.

Additional Information Regarding Bloomberg Barclays Indices Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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