Bad Behavior

On Monday, August 5th, the U.S. stock market gapped down at the open, dropping as much as 4.25% intraday before recovering to close down by 3%. This marked the sharpest single-day decline in nearly two years. The market recovered over the following days. By the end of the same week, the Monday losses were fully recouped.

A report from 401(k) plan provider Alight Solutions sheds light on how investors responded to that market volatility. The firm saw a dramatic spike in activity, with trading on that single Monday amounting to almost 90% of the trading in the prior month.

Almost all the activity involved investors selling stocks and buying safer assets like money market funds. Notably, 13% of the selling involved Target Date funds, which are supposed to be “set it and forget it” funds that gradually lower their risk profile over time as the fund’s target date nears. Investors apparently abandoned their plans to forget it.

The lesson here is not that markets will always go back up, although given enough time they have in the past. The lesson is to have a thoughtful plan and stick to it. We should resist the impulses that cause us to sabotage our own investment success. Dear reader, I speak from experience.

Half the battle is knowing the behavioral pitfalls to which we are vulnerable so we can avoid them. Here are some common ones:

Overconfidence: A good way to illustrate this one is the survey that found 93% of drivers think their driving skills are above average. A study titled “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” found that the individual investors who traded most actively earned significantly lower returns than those who traded less frequently.

Anchoring Bias: Anchoring occurs when individuals rely too heavily on an initial piece of information (the “anchor”) when making decisions. In the context of investing, anchoring can lead to irrational decisions because investors become fixated on specific reference points, such as the original purchase price of a stock or a past market high, rather than considering the full range of relevant information.

Endowment Effect: The Endowment Effect is a bias whereby individuals ascribe more value to something merely because they own it. This phenomenon can lead investors to make poor decisions such as holding assets longer than they should simply because they own them, rather than based on the merits of the asset.

Recency Bias: Recency bias occurs when individuals give undue weight to recent events or information when making decisions, often at the expense of long-term trends or historical data. In investing, recency bias can hurt investors by causing them to overreact to short-term market movements or recent performance, ignoring the broader context.

This last one likely drove those 401(k) investors to sell. I would argue the greatest impediment to long-term investment success is not a lack of knowledge or experience. It is the fortitude required to stay the course with a plan when the next market downturn comes.

Jeff Buck