| Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it. |
Psychological research has shown that the less extreme we expect an outcome to be, the bigger our emotional reaction to it. So, it's natural that the market volatility caused by the unexpected coronavirus pandemic is leading to strong emotional reactions, as investors ask themselves difficult questions about what's best for their portfolios.
Unfortunately, there's no certain answer. And this uncertainty leaves us uneasy--research shows that dealing with uncertainty might be one of the things we dislike the most.
In fact, there's a strong correlation between uncertainty and negative emotions such as stress and anxiety, which have the potential to bias our decisions. Uncertainty also causes us to become hypervigilant to our surroundings, which increases our stress levels and makes us especially defensive.
To better understand uncertainty and its effects, let's consider how its three ingredients play into the market.
- Probability, or risk: We often base our decisions to buy or sell on the probabilities we construct on anticipated performance.
- Ambiguity: When it comes to investing, the right answer isn't always crystal clear--we can use the same information to reach multiple conclusions, such as when we see several experts give different pieces of advice on the same stock.
- Complexity: There is a great amount of information than we can use to inform our investment decisions.
Here's how uncertainty and its ingredients surface in investing decision-making.
How Can Uncertainty Impact Investing?
Uncertainty warps our investing behavior in four main ways.
- Hesitancy. When we're dealing with uncertainty, we can withdraw ourselves from the market altogether because we are more hesitant to take risks. Of course, it’s OK to be vigilant around extreme risk, but being overly cautious can lead to financial losses.
- Procrastination. Our increased risk aversion can also cause us to procrastinate making any investment decisions at all, partially to avoid making a decision we'll later regret. The irony is that procrastination itself can actually increase regret about our financial decisions or malnourish our retirement fund.
- Giving in to temptation. Because we are tempted to give in to our "wants" instead of our "needs" when we're dealing with uncertainty, it's especially difficult to do what we should. However, doing so can backfire when investing. Consider the "disposition effect," which is the tendency to sell good stocks too early and sell bad stocks too late. Indeed, when our stocks rise in value, we may want to sell them to get that quick monetary gain, even though we should hold on to them for longer.
- Undervaluation. Uncertainty can bias our judgment about price and lead us to undervalue items. Let's say that someone asks us how much we'd pay for a ticket to a movie we don't want to see, as well as for a raffle that could win us a ticket to either a movie we won't like or one that we will. Believe it or not, in the interest of avoiding uncertainty, we're more likely to pay more for the ticket to the movie we're not interested in than for the raffle (which offers the chance to see a movie we will like). Similarly, uncertainty can translate into overpaying for poorly performing investments.
3 Ways Investors Can Work to Stay Certain When Dealing With Uncertainty
Uncertainty isn't always bad. Here are a few methods to combat its negative effects.
- Don't lose track of your goals. We're less likely to succumb to the disposition effect if we remind ourselves of our goals before making decisions about investments. In fact, keeping track of our goals is a good way to maximize our well-being. Some steps that can help us with our goals include writing down the important goals we set for ourselves, imagining how we’ll achieve them, creating a plan to achieve our goals, and then putting our plan into action.
- Don't overwhelm yourself with information. In dire times, we can find ourselves constantly checking the news. Although keeping informed is beneficial, the news can easily evoke negative feelings that may linger for longer than we may think and may even require psychological interventions. Importantly, exposure to a big wall of information can bias our financial judgments. This means that we might end up overpaying for an investment if we find ourselves glued to news while feeling uncertain. So, how can we avoid the uncertainty from the news while still keeping informed? One study showed that following the news with brief, simple relaxation exercises, such as listening to music, can buffer negative psychological effects. In other words, simple relaxation methods can go a long way toward managing the stress of the news we hear everywhere we go.
- Don't lose hope. It's easy to fall into a slump when dealing with uncertainty, but a sense of hope can be a powerful ally in persevering through a storm. One way to boost hope is to boost optimism, as they go hand-in-hand. In times of stress, that may seem to be easier said than done, but increasing optimism can actually be pretty easy. One beneficial activity is to imagine our "best possible self," or the person whom we'd like to be in the future if everything in our life goes as planned. We can make that person feel more real by thinking further about three domains of our best self: how we want to be on a personal level, on a professional level, and on a relational level. By using these tactics to strengthen hope, we're able to face the future with healthy emotional appraisal strategies and better cope with the challenges life throws at us--and we have reasons to feel hopeful when looking at the market ahead. After all, facing uncertainty optimistically can sometimes make it a more enjoyable experience.