Steve Wendel

Updated: August 15th, 2019

The scenario is all too familiar: The market takes a tumble and clients are on the phone with their advisors, wondering what’s happening to their money and what they can do about it.

Investors may naturally fear a further drop in the markets. And given how our minds judge probability and forecast the future, it’s understandable that investors might want to pull out of funds.

Successfully navigating these moments can be easier if advisors understand the particular causes of financial anxiety for investors. Instead of asking themselves if their client is doing the right thing, they should be asking themselves, “Why is this moment happening?”

How market volatility impacts investor behavior

People use the recent and vivid past as a guide. We’re hard-wired to see things that readily come to mind as indicative of the future. For example, vivid and recent things, like a drop in the stock market, are far more compelling than events in the distant past (e.g., Tversky and Kahneman 1973). If you think about it, this make perfect sense in our everyday life. If we see a car coming straight at us, we don’t recite in our heads, “Past performance doesn’t predict future performance. Therefore, the car is going to swerve. I’m safe.” No, we take the recent and vivid past as a guide for what’s going to happen next. In investing, that’s sometimes referred to as our recency bias.

People watch how others respond. There’s another cognitive bias that comes into play. When people see how others are responding to a market event like Brexit, often their first instinct is to react in the same way (e.g., Nolan et al. 2008). It’s hard to go against social norms, and we fear social rejection if we do. As in everyday life, it can be quite reasonable to follow the group if you don’t have good information. 

But when it comes to investing, these biases can lead us astray. Assuming short-term market volatility is going to lead to a long-term, permanent loss of capital isn’t useful. It’s the opposite. And, if you see the herd going one way, that means there are opportunities in another direction.

Recency bias and herding behavior are egged on further by the headlines and social-media doom that accompany market volatility, making it feel more real and immediate than a carefully considered, long-term plan that a client agreed with years ago.

Advisors can have a calm, rational discussion with an anxious client about how market instability is probably going to be overblown. But if the client’s neighbor is screaming about how we’re all going to lose everything, that overrides everything else.

How advisors can address financial anxiety

Vividness matters. People often get anxious about market volatility in part because of that vividness. The more vivid it is, the more real it feels.

Advisors can fight vivid with vivid. Give a vivid example of other investors who gave in to herding behavior in the last major scare and then lost their house or their retirement. This isn't to scare people, but to make the outcomes clear and vivid.

Then give a vivid, real, personal example about the people who stuck to their long-term plans through a scare and did really well. The abstract is useless. It’s about how well you can visualize that person who actually did it right.