The Impact of Negativity Bias on Investing
June 5, 2014 | Your Finances
We’ve all felt it: the uneasy feeling gnawing at your stomach that something will go wrong. That nagging voice inside your head that tells you there is no way you can win. The tightness in your chest that reminds you it’s better to be safe than sorry.
This phenomenon is called “negativity bias,” and it’s what causes investors to put more weight on bad news than on good. Over and over, the brain tends to react to negative events more quickly, strongly and persistently than to good ones.
That makes sense from an evolutionary standpoint; the brain is wired for survival. If you’re walking down the street and you see two women, one carrying a delicious-looking cake and another wielding a baseball bat, you’re going to focus on the one who can do you harm.
In this sense, negativity bias can be helpful. It can help keep us safe in this world. But negativity bias is also what leads us to dwell on bad news or to overestimate the risk that a negative event will occur rather than embracing the possibility of a positive one. That can be damaging to your future, especially when it comes to investing.
The recent bull market provides a perfect example.
Negativity bias and the fear of another market meltdown is what caused some long-term investors to pull their money out of stocks in 2008. It’s also what kept many sitting on the sidelines as the market rebounded in what is now the fifth-best bull run in history.1 Yet despite this upswing, investors continue to feel spooked at even the smallest of market tremors.
According to EPFR Global, panicked investors yanked $6.3 billion from emerging-market stock funds in a single week in February 2014. While this record outflow was linked to concerns about growth prospects in emerging markets like China and Argentina, investor fears were also likely driven by memories of 2008. But as the market soon proved, the decision to sell was a costly one; investors who sold their shares missed out on a rebound that carried emerging market stocks to an all-time high just weeks later.
So what can you do to combat negativity bias when investing? The truth is, markets can and do correct, and volatility is a natural part of investing.
Long-term investing isn’t about hunches, emotions, or making quick profits. It’s about using sound strategies to accumulate wealth over time. By practicing a few tried-and-true investment principles, you may be able to tune out market negativity and focus on reaching your financial goals. Here are five tips worth repeating:
1. Know where you’re going. Living with market volatility is a lot easier when you have a sound asset allocation strategy. Your asset allocation defines the mix of investments that can help you reach your goals, based on your risk tolerance and where you are today, where you want to go, and how long you have to get there. Unless something significant has changed in your life, it’s often best to leave your allocation as is.
2. Diversify, diversify. It’s next to impossible to consistently predict which area of the market will be next to outperform. Yet many investors make the mistake of jumping on the bandwagon and investing in whichever asset class is hot at the moment. Unfortunately, by that time much of the returns have already been had. You can take the emotion out of investing by owning a broadly diversified mix of investment types. A diversified portfolio can help ensure that you’ll have exposure to the next asset class upswing before it happens.
3. Don’t try to time the market. Historically, the stock market has posted a consistent record of rebounding over time. The challenge is that we don’t always know for certain when it will happen. Keeping your money invested during a market downturn may take a strong stomach, but it’s a good way to ensure that you won’t miss the next rally. Remember, upward market moves tend to happen in short bursts. To make sure you don’t miss out on these powerful upswings, you have to stay invested–even if it means taking your lumps in a downturn.
4. Use volatility to your advantage. Market downturns can make investors nervous, but they’re not necessarily bad. Sure, it takes extra discipline to keep investing when prices dip, but when you invest a fixed amount each month or each paycheck, you’ll acquire more shares when prices are lower and fewer when prices are high. In the end, dollar-cost averaging may provide an average return that could be higher than if you invested all of your money at once.
5. Be realistic about returns. Over the past five years, stocks, as represented by the S&P 500 Index, have return a rich 17.9 percent a year–way more than the 25-year average of 10.3 percent. Keeping your expectations at reasonable levels may make it easier for you to stand your ground if and when the markets turn direction and head lower.
It isn’t always easy to overcome emotions and maintain a long-term perspective through volatile markets; however, it can be rewarding. For many investors, working with a qualified investment professional can help. A financial professional can show you how sticking with a solid investment strategy can help you remain focused on achieving your financial goals, even during times of market uncertainty.
1S&P Dow Jones Indices, March 2014.