Nobel Prize-winning psychologist Daniel Kahneman demonstrated this with his loss aversion theory, showing that people feel the pain of losing money more than they enjoy gains. The natural instinct is to flee the market when it starts to plummet, just as greed prompts people to jump back in when stocks are skyrocketing. Both can have negative impacts.
We don’t know what the rest of this year will bring. But smart investing can overcome the power of emotion by focusing on relevant research, solid data and proven strategies. The following principles can help fight the urge to make emotional decisions in times of market turmoil.
Market declines are part of investing—
Over long periods of time, stocks have tended to move steadily higher, but history tells us that stock market declines are an inevitable part of investing. The good news is that corrections (defined as a 10% or more decline), bear markets (an extended 20% or more decline) and other challenging periods haven’t lasted forever. The S&P 500 Index has typically dipped at least 10% about once every 18 months, and 20% or more about every six years, according to data from 1954 to 2024. While past results are not predictive of future results, each downturn has been followed by a recovery and, over time, a new market high.
Time in the market matters, not market timing—
No one can accurately predict short-term market moves, and investors who sit on the sidelines risk losing out on periods of meaningful price appreciation that follow downturns. Every S&P 500 decline of 15% or more, from 1929 through 2024, has been followed by a recovery. The average return in the first year after each of these declines was 52%. Even missing out on just a few trading days can take a toll. A hypothetical investment of $1,000 in the S&P 500 made in 2014 would have grown to $2,869 by the end of 2024. But if an investor missed just the 10 best trading days during that period, he or she would have ended up with just $1,571, or 45% less.
Emotional investing can be hazardous—
Kahneman won his Nobel Prize in 2002 for his work in behavioral economics, a field that investigates how individuals make financial decisions. A key finding of behavioral economists is that people often act irrationally when making such choices. Emotional reactions to market events are perfectly normal. Investors should expect to feel nervous when markets decline, but it’s the actions taken during such periods that can mean the difference between investment success and shortfall.
One way to encourage rational investment decision-making is to understand the fundamentals of behavioral economics. Recognizing behaviors like anchoring, confirmation bias and availability bias may help investors identify potential mistakes before they make them.
Make a plan and stick to it—
Creating and adhering to a thoughtfully constructed investment plan is another way to avoid making short-sighted investment decisions — particularly when markets move lower. The plan should consider a number of factors, including risk tolerance and short- and long-term goals.
One way to avoid futile attempts to time the market is with dollar cost averaging, where a fixed amount of money is invested at regular intervals, regardless of market ups and downs. This approach creates a strategy in which more shares are purchased at lower prices and fewer shares are purchased at higher prices. Over time investors pay less, on average, per share. Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.
When stock prices fall, you can get more shares for the same amount of money and lower your average cost per share. Retirement plans, to which investors make automatic contributions with every paycheck, are a prime example of dollar cost averaging.
Diversification matters—
A diversified portfolio doesn’t guarantee profits or provide assurances that investments won’t decrease in value, but it does help lower risk. By spreading investments across a variety of asset classes, investors can buffer the effects of volatility on their portfolios. Overall returns won’t reach the highest highs of any single investment — but they won’t hit the lowest lows of any single investment either.
The market tends to reward long-term investors—
Is it reasonable to expect 30% returns every year? Of course not. And if stocks have moved lower in recent weeks, you shouldn’t expect that to be the start of a long-term trend, either. Behavioral economics tells us recent events carry an outsized influence on our perceptions and decisions.
It’s always important to maintain a long-term perspective, but especially when markets are declining. Although stocks rise and fall in the short term, they’ve tended to reward investors over longer periods of time. Even including downturns, the S&P 500’s average annual return over all 10-year periods from 1939 to 2024 was 10.94%.
It’s natural for emotions to bubble up during periods of volatility. Those investors who can tune out the news (noise) and focus on their long-term goals are better positioned to plot out a wise investment strategy.
