Humanity, Market Volatility, and the Long-Term Investor
“The stock market is a device for transferring money from the active to the patient.” —
Warren Buffett
Market volatility is once again making headlines, and it seems to have come as a surprise for many. From geopolitical tensions and shifting monetary policies to unexpected economic data and swings in market sentiment, investors are constantly being tested. Yet, while it may feel like we are in uncharted territory, the reality is that volatility has always been a fundamental part of investing. The difference between success and failure is how we choose to respond to it. This edition of the Chronicle aims to shed light on what we consider the most important strategies for long-term investors to stay focused, remain resilient, and make prudent decisions amid the noise.
Prospect Theory
Investing can be hard, as just about anyone who’s ever done it can attest. Humans naturally want certainty, and that’s just not on offer from the markets. No one we know of has ever been able to reliably predict what the market will do, although some have occasionally guessed right. We’d point out that every time they didn’t guess right, they got it wrong.
Economists and psychologists have been trying to understand investor behavior for many decades. There’s an entire field of academia known as behavioral economics (sometimes called behavioral finance). In 1979, two giants of this field, Daniel Kahneman and Amos Tversky, developed what they called prospect theory, which asserts that people tend to make choices based on perceived gain and loss,rather than objective outcomes. Many insights into human decision-making—particularly as it relates to investing—can be found by looking into prospect theory.
One of the core tenets of prospect theory is that people experience losses more intensely than gains of the same magnitude. For example, losing $100 hurts more than the pleasure gained from winning $100. This psychological asymmetry often leads investors to make overly cautious or risk-averse decisions, especially after experiencing financial losses.
Prospect theory postulates that individuals evaluate outcomes as gains or losses relative to a reference point rather than their final outcome. For example, if an investor purchases a stock at $50, and it rises to $70, the new reference point becomes $70. If the stock later falls to $60, the investor perceives this as a loss, even though there’s been a net gain. Is any of this starting to sound familiar?
Prospect theory can get a little dense. For example, the value function in prospect theory is concave for gains and convex for losses. This means the subjective or emotional value of each additional unit decreases as the gain or loss increases. For instance, the difference in emotional impact between losing $100 and $200 is more pronounced than between losing $1,000 and $1,100.
While people are generally risk-averse when dealing with gains, they tend to become risk-seeking when faced with potential losses. This explains why some investors hold on to losing stocks in the hope of a rebound rather than accepting a loss and moving on. Other behavioralists have called this desire to sell winners too quickly and hold losers too long the disposition effect. We love to declare victory but hate to admit defeat.
We quoted Warren Buffet earlier, so let’s look at the reality of his wisdom. If someone had invested $100 in the S&P 500 in 1928 and reinvested all dividends, the investment would have grown to approximately $93,000 today. That’s a great example of the power of compounding; so is the fact that Buffet himself has made approximately 85% of his considerable fortune since he turned 65.
Prospect theory has significant implications for investors, but it’s actually a pretty simple concept. Our emotions work against us, but there is a remedy. Find a level of downside portfolio loss you can live with, and then let compounding do its thing. Patience is the ultimate lesson of prospect theory.
Market Timing: Very Bad
Market timing is the practice of buying and selling financial assets to capitalize on market fluctuations. Another word for it is speculation, but it always involves making predictions about uncertain events. Often, those predictions are made at exactly the wrong moment, and that is what Hahneman and Tversky were trying to understand.
Day traders will call market timing a strategy driven purely by analysis and data, and statistics like momentum and correlation. For many investors, however, market timing isn’t a strategy; it’s a reaction to a variety of biological and physiological factors. Ultimately, for those people, it comes down to panic selling and FOMO buying.
The brain’s limbic system, responsible for processing emotions, plays a crucial role in market timing. When the market tumbles and portfolio values fall, the amygdala triggers fear and anxiety and an overpowering urge to flee—to sell. Conversely, dopamine release, associated with reward and pleasure, can reinforce buying behaviors during upward market trends, which can trigger the fear of missing out. This cyclical response pattern often leads to buying high and selling low—the exact opposite of successful investing.
We can all take some comfort from the fact that this is our nature; humans are wired to respond swiftly to perceived threats and opportunities. Psychologists call this the flight-or-fight response. Market timing, driven by the fear of loss or the excitement of gains, can result from deeply ingrained survival instincts that prioritize short-term safety over long-term rationality. In investing, you really want to avoid that if you can.
If any of this is ringing bells for you or reminding you of your past investing mistakes, good. Understanding your own essential humanity can help you recognize your biases and adopt more disciplined approaches. Basically, it comes down to this: you have to know how much you can endure and adjust your portfolio strategy accordingly. Armed with this information and a data-driven understanding of what your maximum downside exposure is, you can make it through even the roughest bear markets.
Stay Focused on Your Goals
Discovering your emotional floor, the lowest level your portfolio could fall to without driving you to market time, is hugely valuable, and it’s a great first step for just about anyone. But there is more you can do: you can stay focused on your financial plans, which ideally have been designed to weather market turbulence and keep you above your floor.
A competent and empathetic financial advisor can design an investment strategy built with your unique goals and risk tolerance in mind. Whatever your long-term goals—retirement income, wealth preservation, or growth—making drastic changes based on short-term volatility really only hurts you.
Plans made in your forties may not seem like such a good idea when you’re in your sixties or seventies. It’s prudent to review your plan and portfolio periodically to ensure it still aligns with your long-term objectives. Market shifts can change your risk exposure, and rebalancing may be necessary. We don’t advocate for “set it and forget it” portfolios, but favor annual reviews to make sure your strategy reflects your situation, which will very likely change over time.
Think Long-Term, Act Long-Term
Trying to time the market rarely works. Academic studies consistently show that missing just a handful of the market’s best-performing days can significantly reduce long-term returns. For example, data from J.P. Morgan Asset Management shows that missing the 10 best trading days over a 20-year period can cut returns by more than half. Investing seems hard, but it’s also pretty simple: you can have 100% certainty of capturing those 10 best days simply by staying invested continuously. So there is some certainty on offer after all.
Rather than reacting to short-term headlines, long-term investors should focus on maintaining a disciplined strategy. This means continuing to invest through down markets and resisting the urge to exit positions prematurely. With experience, you may begin to see the upside of downturns.
While volatility may seem like a threat, it also presents opportunities for long-term investors. Market downturns can create attractive entry points for high-quality investments at discounted prices. Dollar cost averaging, contributing a fixed amount on a regular, periodic basis, can work to reduce your overall cost basis.
Downturns can also provide an opportunity to rebalance your portfolio by buying undervalued assets and trimming overvalued positions. And here’s a big one: Realizing losses, even on stocks you love, can help offset capital gains and reduce tax liabilities. Just remember to wait 31 days to buy that beloved stock back so you won’t violate the Wash Sale Rule.
Stay Informed, Not Overwhelmed
We live in a wired world, and it’s easy to find something to worry about. The 24-hour news cycle is not the friend of the long-term investor. While staying informed about the big things is important, it’s equally important not to let media drama drive your investment strategy. Instead, focus on credible, objective sources and avoid making decisions based on sensationalist reporting.
We can tie all of this together with some fascinating research about another behavioral phenomenon called myopic loss aversion. Research shows that the more frequently an investor inspects their portfolio, the riskier they perceive it to be. There appears to be a correlation between monitoring and success, and it’s inverted: the less frequently you check on your account, the better you do.
An investor who checks their portfolio quarterly rather than daily reduces the chance of seeing a moderate loss (-2% or more) from 25% to 12%. This reduced exposure to perceived losses means fewer emotional stressors and less temptation to make decisions based on loss aversion.
Market volatility is nothing new, and will be with us always. Find that emotional floor, that point of maximum loss you can tolerate, and adjust your portfolio accordingly. Remember that Buffett is right about what the market actually is and that a disciplined, long-term strategy has tended to be the smart, winning strategy.
