Editor’s note:Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.
The biggest threat to investors’ financial plans may not be COVID-19, but rather their own minds. As market volatility continues, one of the precautionary tips making the rounds among social circles is to get out of the market. Even if an investor manages to avoid panicking after those conversations, a look at the news or a single scroll on their news app may bring their worries back to the forefront. In times like these, even the most logical investors can have trouble staying on track.
When in Doubt, Herding Behavior Tells Us to Follow the Crowd During times of market volatility when many investors are running for the hills, it’s natural to want to follow. This is a common phenomenon many financial professionals are familiar with: herding behavior.
In a time when many investors may be falling prey to this bias, here’s a quick primer on what can drive this behavior:
We are more prone to herding behavior when making difficult decisions. In everyday life, when we’re not sure about something, it’s usually a good idea to follow the crowd. This is an example of our "System 1" in action, in which our minds find ways to take a shortcut instead of solving a complex problem. So, if investors are not confident about their investing-related expertise, their minds may automatically choose to follow the crowd. And unfortunately, when it comes to finances, the crowd is usually running in the wrong direction.
Going against the crowd is emotionally draining and can even be physically uncomfortable. Our instincts tell us to fit in and not be left behind. When you ask a client to do the opposite, it’s important to understand how unnatural this feels.
Herding bias is especially prevalent during times of uncertainty. Pandemics aren’t declared too often. Thus, on top of the usual uncertainty that goes along with investing, herding behavior is especially heightened because of the uncertainty that comes with COVID-19 and the impact it can have on investors’ lives and finances.
Not following the crowd requires us to engage the more rational side of our minds and make a more logical choice. Unfortunately, that requires attention and, right now, an investor’s attention is already juggling multiple concerns like making sure they sanitize everything and have enough toilet paper.
How to Help Clients Think Twice About Herding Behavior Although our minds may naturally work against us in these turbulent times, there are ways to help your clients stick to their long-term plans:
Keep clients informed. No one likes being left in the dark, and, as discussed, investors are at greater risk for herding behavior when they’re uncertain about their current situation. This is a great time to talk to clients about their financial plans and emphasize why their portfolio is still well-positioned to reach their financial goals. It may also help to give clients a clear-headed view of the market today. Morningstar healthcare strategist Karen Andersen and equity analyst Preston Caldwell recently explained how coronavirus volatility may continue in the short term, but long-term impact looks to be minimal.
Set up points of friction. Sometimes clients need a friendly nudge to encourage them to engage their "System 2"--the logical side of the brain. For instance, maybe your nudge can be to remind clients of the fees and tax implications of trading and turnover in general, especially in taxable accounts. Another nudge can be to remind clients of those who cashed out during the global financial crisis. As the graph below shows, those who stayed the course with their investments did recover—and saw visibly better returns—within a few years.
Help clients redirect their worry. Help clients see the coronavirus volatility as a way to buy some investments at a discount and maybe reach some of their stretch goals. This tactic is a way of practicing anxiety reappraisal, which entails reframing nervousness as excitement. Although it’s easier said than done, Morningstar director of behavioral finance Sarah Newcomb explained how you can do it in a recent post.
Although it may seem irrational to you that a client is following the crowd, it may not be irrational at all. Your client may be using a shortcut that generally works but simply isn’t appropriate for this scenario. During these tough times, it can help to understand what’s behind your client’s behavior so you can help steer them in the right direction.