Written by Preet Banerjee

Friday, November 9th, 2018

When markets are “selling off," which is just investment-speak for losing value, it can be easy to question our investments. The idea of losing money is an emotionally painful one. But acting on our emotions and changing our long-term investment plans due to short-term events is one of the most common mistakes investors make.

Focus on the Long Term when Investing

Historically, investors would've been rewarded for staying the course through the ups and downs over long periods of time in the markets with a well-diversified portfolio.

To visualize this, see these two charts which show Canadian stock market growth for almost 100 years. (It's particularly important to look at the second chart which normalizes percent gains and losses over time – it shows that what might initially look like a more volatile market today is nothing compared to the Great Depression.)

What you'll also see is that the market doesn't seem to show a clear pattern over short periods of time, but over long periods of time, there's been an upward trend.

Don't Try to Make Sense of the Short-Term

If you want another example of how the short-term market movements are unpredictable, try playing this stock market simulator. It takes a random 10-year period for the S&P500 (U.S. stock market) and gives you $10,000 to start. In about a minute or less, it will graphically run through what actually happened to the market and allow you to try to see how hard it would be to spot a downturn. You're allowed to sell once and buy back in once. Play a few rounds and see if you can time the market. It's much harder than you might expect.

Our Emotions Can Lower our Returns

A study published in 2005 in Psychological Science¹ showed the results of an investment exercise, in which participants who had experienced brain damage leading to a reduction in emotion outperformed participants who had not experienced such brain damage. Why? A reduced level of fear allowed them to make more prudent investment choices.

Participants in this study were asked if they wanted to bet $1 on 20 consecutive coin tosses. For each coin, they could choose not to play and keep the $1, or they could flip the coin. If the coin landed on heads, they'd get $2.50 (a gain of $1.50). If the coin landed on tails, they'd lose their dollar.

Because each coin flip is a 50/50 bet, and because the gains if you won were higher than what you could lose if you lost, statistically it made sense to play every round. But because a few losses in a row would induce fear, it caused participants who had not experienced the brain damage to avoid placing a bet in subsequent rounds. However, participants who had sustained brain damage ended up playing more rounds and winning more money overall. They were found to be more reasoned and less fearful.

This is the academic equivalent to some common investment wisdom: “It's not about timing the market, it's about time in the market."

Behaviour Substitution

Dieters often find success in modifying their eating behaviours using “if-then" plans. “If" they feel hungry, “then" they grab an apple before doing anything else. The carbs in the fruit may satisfy their sugar craving, and a few minutes later their brain gets a signal from their stomach that says "I'm not hungry anymore." And since the apple is a healthier choice than a donut, they may start to see their health improve.

A similar approach to modifying your investment behaviour may work. “If" the market is selling off, “then" increase your automatic contributions by 10% for the next quarter. This may help you feel that lower prices of the markets from time to time are something you can take advantage of, rather than fear. (One could argue that this is another form of market-timing, and in a sense that's true, but the change is a relatively small one, and the benefits are more about changing your perspective on long-term investing.)

Where to Go from Here?

It's possible that markets continue to sell off for months. But months are short-term timeframes in the world of investing. And you need to be fully prepared for that as a possibility. It's also possible that markets could stabilize and even rebound quickly.

No one knows what will happen in the short term, but we do know that when events like this have happened in the past, people with well-diversified portfolios who stuck to their plan were rewarded in the long term.

¹ Shiv, B., Loewenstein, G., Bechara, A., Damasio, H., & Damasio, A. R. (2005). Investment Behavior and the Negative Side of Emotion. Psychological Science, 16(6), 435–439.