Asset Matters: Just Stop the Pain

Understanding emotional reactions to market pullbacks can improve investment decisions.

If your portfolio has experienced a prolonged period of capital gains, a market pullback may not concern you because you may feel like you're "playing with house money." The prospect of further losses or losses that erode principal, however, can produce significant anxiety and spur a desire to protect remaining gains. Unfortunately, the response to this anxiety may be to abandon carefully laid investment plans, which can derail long-term goals.

Stock market pullbacks are often quickly followed by plummeting investor outlooks. A real-time example: After the tumultuous start to 2016 for global equity markets, a weekly poll that tracks investor sentiment showed that the percentage of investors who characterize themselves as "bullish"-meaning that they expect stock markets to go up in the next six months-had declined to a 30-year low. 1

Bullish Sentiment Often Declines with Stocks

Bullish 8-Week Moving Average

Source: American Association of Individual Investors.

Emotions in the Driver's Seat

Is this type of reaction rational? Stock markets have been volatile since mid-2015, but several quarters on, global central banks remain accommodative, the economy continues to expand and corporate profits remain healthy. Market swings, however, may matter more to investor emotions than a collection of positive data points. This underscores an idea that has garnered plenty of research support: Investing is not always rational. In fact, it's often quite emotional.

The human inclination toward pessimism in response to the first signs of market loss results from a tangled web of psychological tendencies. The field of behavioral finance-which combines elements of psychology and finance in an effort to understand investors' decision-making processes-seeks to untangle these forces. The concept of loss aversion, for example, refers to the human tendency to feel the sting of losses more acutely than the pleasure arising from the same magnitude of gains-a key factor in how we respond to market pullbacks. By evaluating potential weak points in our thinking, the hope is that we can ultimately steer ourselves away from making poor investment choices.

Tracking Shifts in Risk Tolerance

Of the many factors that influence portfolio design-risk tolerance, time horizon, asset class preference, and income and liquidity needs-risk tolerance is often key. Yet investors' profound emotional reactions to bumpy markets beg the question: how stable is risk tolerance? If an investor's risk tolerance changes in up markets compared to down markets, is a "moderate" investor always a "moderate" investor, or does one become "conservative" when markets are falling and "aggressive" when markets are climbing?

The evidence that investors become conservative at exactly the wrong time is plentiful. For example, we can track how mutual fund investors move to higher cash allocations after markets begin to fall, woeful timing that can lock in losses and set them up to miss a potential market rebound. An investor's unwillingness to ride out downturns can undermine the foundation of a well-thought-out, long-term, strategic asset allocation.

Researchers have explored the pervasiveness of this tendency for risk tolerance to shift with market movements. One study tracked the risk tolerance of a group of investors between 2007 and 2012 and compared it with movements in the S&P 500 during that period. The study's authors, two university professors of financial planning, had the good fortune of capturing the market as it went from an all-time high through one of the deepest pullbacks in stock market history and back up again-a period tailor-made to showcase the full spectrum of investor emotions.

The study found that risk tolerance scores were indeed highly correlated to S&P 500 levels, registering an overall correlation of 0.7. (Correlation is a statistical measure in which 0 suggests that two things are completely unrelated and 1 shows perfect interrelation.) Monthly risk tolerance scores showed a tendency to increase when stock values were high and decrease when stock values were low. The correlation increased to 0.9 when the S&P 500 was down. Put simply, investors demonstrated less willingness to take on risk as stock market valuations became more attractive and vice versa, and the effect was particularly pronounced during down markets.

Fall Into Good Habits

By becoming aware of our potentially problematic investing practices, we can take steps to institute positive changes. Just as you can lure yourself into forming bad habits that work against you, it's also possible to learn better ways to do things-to fall into good habits.

Once you've set up a process and a plan that makes you comfortable, you can take advantage of the upside of procrastination. Keep it going and, if possible, don't think about the funds as long as possible. Historical data has shown that the longer the investment period, the better the chances of achieving attractive returns (see chart). Periods of volatility are to be expected when investing for the long-term.

Percentage of Positive S&P 500 Outcomes Has Varied by Holding Period

Source: FactSet. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

For most investors, the salient point is to know how common this effect is, when it comes to our feelings about recent losses and the immediate future. Much like we all know that it's a bad idea to go grocery shopping when you're hungry, we would suggest that evaluating your portfolio design right after a pullback or market loss is likely to be colored by a greater tendency to avoid risk. Being aware of the most common reactions to market pullbacks can help reassure investors that their emotions are quite normal, but their long-term plans are still intact.

1 Source: AAII Investor Sentiment Survey , as of March 23, 2016. The 30-year low refers to the eight-week rolling average of investors reporting that they are bullish.

2 Source: Michael Guillemette and Michael Finke, 2014. "Do Large Swings in Equity Values Change Risk Tolerance?" Journal of Financial Planning 27 (6): 44-50.

This material is provided for informational purposes only. Nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The views expressed herein are generally those of Neuberger Berman's Investment Strategy Group ( ISG ), which analyzes market and economic indicators to develop asset allocation strategies. ISG consists of a team of investment professionals who consult regularly with portfolio managers and investment officers across the firm. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results . Please see disclosures at the end of this publication, which are an important part of this article.

© 2009-2016 Neuberger Berman LLC. | All rights reserved

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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