Market Mini: Reasons Why Stock Investors ‘Freak Out’

Posted By on Mar 14, 2014|0 comments

The stock market has had a good run and may last several more years. But if you have been in the financial planning business for any length of time, this state of the market we know is only temporary. There will come a time in the market when individuals will lose money. For this, financial advisors need to be well prepared.

In a recent study titled Why Stock Investors Freak Out, researchers Danielle Winchester, Sandra Huston and Michael Finke shed light on client panic during market downturns—and how advisors can limit their portfolio damage.

They discovered that one of the main reasons behind the success of Weight Watchers is because of accountability. Similarly, this is also why the AUM in Box coaching program works: financial advisors want to be held accountable with sales training. And, it is one of the reasons why clients seek financial advisors, because financial advisors hold their clients accountable to a plan.

Back to the study … Winchester, Huston and Finke found that individuals were much less likely to freak out when stock prices declined if they had a plan. Their emotional state was also more likely to be stable when advisors kept them focused on longer-term goals.

Create a Plan to Stay On Your Financial Course

Plans are best created in an investment policy statement that includes how to allocate investments, tax policy, income needs and an estate plan. It does not need to be long, as a minimum of one page will likely suffice.

Winchester, Huston and Finke indicated that “one of the strongest predictors of maintaining one’s portfolio allocation was whether or not they used a financial advisor. Even in a controlled wealth and investment experiment, the use of an advisor increased the likelihood of staying on course by 50%.”

The Investment Company Institute found that stock investors withdrew $28 billion in January 2009, $29 billion in February and withheld $25 billion in March. Investors sold right at the bottom. If you had purchased shares in an index fund during these three months, you would have seen a significant increase in value. Needless to say, stock investors paid royally for ‘freaking out’ right at the bottom of the stock market.

When individuals are in a difficult state, they seem to believe that they will continue in that state eternally. This is the hardest mentality to overcome. In behavioral finance, this is called “projection bias”. As we all know, this hardly ever happens, if at all, but this is how we think when things get bad.

There are many ways in which a financial advisor can help when a client experiences this feeling of panic. One way that advisors can help is by talking individuals out of this state. Second is by forcing individuals to compose a plan and to enforce it when stock prices decline. Third is to keep individuals focused on their long-term goals.

I often think that as financial advisors, we act more like psychologists than we do as planners. When the stock market declines, I am surer of this than ever.

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