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Market Update, Investor Psychology, and Risk Cycles

Market Update, Investor Psychology, and Risk Cycles

June 28, 2022

The stock market has been experiencing a lot of volatility lately, and we feel it is good for us to stay in touch with our clients during periods of stock market volatility.  First, we don’t believe you should be worrying, but we understand it is completely normal for people to worry, and may even feel anxiety during stock market declines.  That is part of what makes us human.   We are wired to sense danger and immediately go into a “fight or flight” type of mindset.  This mindset helped the human species survive since prehistoric times, but, it is not the right mindset for dealing with stock market declines.  It actually causes people to make investment mistakes. 

Ok, we are going to get a little technical now, but we don’t know an easier way to explain this:  

There have been many studies on investor behavior with interesting findings on our biases. For example, loss-aversion bias is a cognitive bias for individuals describing how the pain of losing is twice as powerful as the pleasure of gaining. Loss-aversion explains an individual’s tendency to prefer avoiding losses to experiencing equal gains. The overwhelming fear of loss can cause us to behave irrationally and make poor decisions. Understanding this is why it’s important to take a long-term planning approach with a diversified mix of investments that align with your overall plan, risk tolerance, and time horizon.

The image below shows an example of the risk cycle for investors. As markets are climbing higher, we tend to have more confidence when investing as we experience gains and news headlines are very positive. However, over time this can lead to more risk taking among participants as investors feel excitement and euphoria. It is at this point where we are also at higher levels of risk as prices reach elevated levels and become more vulnerable, even though we feel good at the time. The opposite feelings occur during market declines when participants feel anxious or fearful and news headlines are pessimistic. However, it’s important to remember that this is also the environment for greater opportunity and potentially more attractive future returns. Interestingly, it’s at these greater moments of future opportunity that our psychology has the tendency to make us feel the need to do something or abandon good investments, which can lead to significant ramifications for the future value of our portfolios.

Source: Capital Group

Many prominent investors are aware of the cycle of investor emotions and have trained themselves to act rationally during moments of market stress. They view these moments as an opportunity to accumulate more shares of sound companies as they work towards building future wealth. Most have likely come across the name Warren Buffet at some point or another. Being known as the “Oracle of Omaha”, he is arguably one of the most successful investors of all time. He has been quoted many times over the years describing his philosophy and how he has become a successful investor, with quotes such as, "we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

We have recently been seeing headlines on a potential coming slowdown in the economy and worries about a recession.  It’s important to remember that the stock market is forward-looking. With the S&P 500 down over 20% and NASDAQ over 30%, much of the recent volatility is due to markets already pricing in the possibility of an economic slowdown. This has occurred during a time that current and recent economic data has still been quite strong. During times of market volatility, it can be helpful to take a step back and look at the bigger picture.

The below chart reflects growth of a hypothetical investment of $10,000 in the S&P 500 in 1926. Areas shaded in green show periods of time in a positive market environment (bull markets) and areas shaded in red show periods in a negative market environment (bear markets). Even though the periods shaded in red tend to be short-lived, they tend to grasp a larger amount of our attention and feelings. However, these periods of time have historically also led to future opportunity and positive market returns on a go-forward basis. Note that data from below shows bear markets tend to be much more short-lived, while bull markets tend to last for longer periods of time. While we never know where the bottom is, declines similar to today or more have presented long term opportunity.  

Source: AMG Funds

OK, enough of the technical explanation. Essentially, you know that we are constantly watching the stock market, and the bond markets here at Exemplar. Our investment advisors meet on a regular basis and try to cut through all of the emotions to make good sound recommendations for you, our valued client. We are planning focused, and are focused on doing the best job possible to help you accomplish your financial goals. Periods of stock market decline are completely normal and worrying about the future is completely normal!  While we never like to see dramatic declines in the stock market, and can’t predict it, they do happen. Exemplar continues to remain optimistic about the long term results and we don’t think this is a time to panic, nor to get out of the market.  That being said, we want you to know that we are here to talk through any concerns that you may be feeling.  


Securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC. 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. All investing involves risk including loss of principal. No strategy assures success or protects against loss.

The example presented is hypothetical and is not representative of any specific situation. Your results will vary. The rates of return used do not reflect the deduction of fees and charges inherent to investing.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.