Lately the stock market has had more twists and turns, sudden plunges and sharp rises than a theme-park roller coaster ride. Not surprisingly, investors can’t help but wonder how to deal with this unprecedented level of volatility.
Global investment markets and economies will continually test investors with unsettling cycles that can’t be controlled. But while these market movements are largely unpredictable, their effect on investor emotions is.
In rising markets, investors are notoriously optimistic; in falling markets that exuberance can quickly fade to pessimism. This cycle can turn rational investors into irrational ones, tempting them to take drastic action and placing in jeopardy their developed, diversified long-term financial plans.
Understanding this cycle of emotions may help investors to manage their response to market fluctuations and remain certain of their financial goals even in times of uncertainty.
The cycle usually starts with optimism - investors commonly expect things to go their way, or more correctly they expect a return for the risk of investing. As stock prices increase, investors feel a sense of excitement, which gives way to euphoria and the belief that prices can only head higher. This is when investors start to chase hot new trends, putting all their eggs in one basket as they try to time the market.
It is at the top of this cycle that investors are at the point of maximum financial risk – a dangerous time when unrealistic expectations typically take hold. Investors often fool themselves into believing that excessive returns are commonplace. As a result, they become blinded to the potential risks at hand. An example of investor euphoria was the tech boom of the late 1990’s.
Of course, rising prices can’t continue indefinitely and all markets inevitably go through periods of decline. As prices drop in value, euphoria gives way to anxiety as investors look to the markets for direction. If the downward trend continues, anxiety quickly turns to denial and fear.
Investors start to question their decisions, even as they wait for prices to recover. Should markets continue to fall beyond this stage, desperation and panic mount. At this point, many investors have lost not only their prior profits, but some of their initial investment capital as well. That’s when they start to act defensively and begin to think about switching out of riskier assets to more defensive shares or other asset classes such as bonds.
The more volatile the markets become, the more emotional investors may get about their investments. In the next phase of the cycle, panic and desperation set in. Some investors persevere, wondering whether the markets are ever going to recover. Many others capitulate, withdrawing from the market altogether, afraid of further losses.
Ironically, it is precisely at this time that investors often fail to recognize that they are at the point of maximum financial opportunity in the stock market. They are so emotionally despondent that the idea of actually buying at bargain-level prices is inconceivable to them.
With the recent turmoil in the stock markets, investors may find themselves at the bottom of the cycle. At this time, it’s crucial to remember that being patient today could represent an opportunity to own investments with real future return prospects.
While you cannot predict when the next upward or downward turn will occur, having a sound financial plan can bring a feeling of confidence that you are well positioned to endure the ride.
A Wealth Management Advisor can help you understand and manage the cycle of investor emotions through market fluctuations. Through the use of our investment philosophy and asset allocation approach, an advisor can help provide the perspective, focus and discipline required to stay on a steady course to reaching your financial goals.
The Northwestern Mutual Wealth Management Company
No investment strategy can guarantee a profit or protect against loss in a declining market.