Volatile market conditions can cause investors a great deal of stress and concern. A falling market may produce large losses on paper, leading some investors to impulsively sell their holdings which can negatively impact their investments and potential long-term gains.
Instead, such volatility can be mitigated by sticking to a long-term financial plan suited to you. In fact, investors who allow their emotions to run away with them tend to see lower overall returns over the course of their lifetimes. Here’s what you need to know about the emotional cycles that drive markets and why you should remain calm during periods of market volatility.
The Cycle of Investor Emotions
tend to follow a fairly predictable cycle that is based on market movements. At each stage of this cycle, investors may feel and act differently, based on the circumstances of the moment. Below are the stages of this cycle:
– Stage 1: Stage 1 of the cycle is reluctance. Investors at this stage tend to be hesitant and worry about taking risks. As the market produces solid returns, however, many people will develop a fear of missing out and overcome their reluctance.
– Stage 2: Stage 2 begins with optimism. A booming market can encourage investors to buy, even when prices are historically high. Optimism gives way to excitement and, eventually, irrational exuberance. Investors take on larger risks, believing the good times will continue.
– Stage 3: Stage 3 of the cycle starts when . Investments made in Stage 2 no longer appear secure. At first, the bad news is usually met with denial. Once market volatility is accepted, though, investors will go through some panic. Once panic takes over, investors may react emotionally and sell their holdings to avoid further losses, causing prices to go into free-fall.
– Stage 4: After taking heavy losses during a panic sale, investors may enter a period of apathy and negativity that can keep them out of the market for years. This eventually resolves back to reluctance, and the cycle begins again at Stage 1.
As you can see, this cycle leaves investors who try to time the market stuck in a never-ending loop. While gains made in Stage 2 may be large, they can be negatively impacted in Stage 3. Selling in Stage 3 locks in those losses, causing investors to enter Stage 4 and restart the process.
How to Avoid Emotional Investment Decisions
Fortunately, you can avoid the entire cycle described above simply by having a long-term, and sticking to it. A good strategy for achieving this is investing in passive index funds. These funds allocate holdings based on the weighted composition of a stock index. As a result, they take the active decision-making out of investing, leaving less room for emotional choices.
You can also use to keep emotions out of your investment decisions. Dollar-cost averaging is a strategy that involves putting a set amount of money into the same assets on a regular, recurring interval without taking price or market performance into account. Over time, this approach allows you to build up holdings at an average cost. With dollar-cost averaging, you can completely avoid the traps that come with trying to time the market. DCA is a great tactic to use against market volatility as making lump sum investments is highly reliant on timing the market, so you may end up investing at a much higher price due to significant volatility in the market.
It is also important to maximize to cut down on risk. A portfolio of stocks in multiple industries, for example, will help you avoid risks that disproportionately affect one industry. Likewise, holding international assets can prevent any one country’s market from dictating the performance of your investments. An even stronger approach is to spread your investments across multiple companies, asset classes, and geographical regions to avoid relying heavily on any one of these. This prevents you from being fully exposed to any one market or asset class, which all may perform differently during times of market volatility.
Finally, you can take emotion out of your investment decisions by tuning out . While major economic shifts may lead you to update your long-term investment plan, most daily headlines should not cause you to buy or sell. Ignoring the drumbeat of market news can help you avoid impulsive decisions that could produce losses later on.
Benefits of Avoiding Emotion in Investing
Over time, this less emotional approach to investing can produce overwhelmingly better results. Rather than going through the boom-and-bust cycle, investors who invest passively, leverage dollar-cost averaging, and diversify their portfolios can see their gains and losses average out positively over time. The S&P 500 index, for example, has returned an average of 10.5% since 1957 (), despite the numerous recessions and market shocks that have occurred in the last 65 years.
Historically, after suffering major losses. Investors who sell during volatile periods lock in their losses, while those who hold are often able to see larger returns during the recovery. The market crash of 1929, the dot com bubble, Black Monday, the 2008 financial crisis, and the start of the COVID-19 pandemic all caused asset prices to plummet. Investors who panicked and sold during these crises suffered considerable losses. In each case, though, global markets eventually recovered, and investors who kept emotion out of their decisions were rewarded.
How to Manage Volatility
As you can see, having a solid plan for investing and sticking to can be the simplest and most effective approach for building wealth in the long run, without stressing about market ups and downs. If you are interested in starting your investment journey off right and continuing for the long term, can help you create a simple, diversified investment plan tailored to your goals and needs.