Volatility brings out the worst in even the best investors. It has a way of clouding our memory and activating our flight hormone, inspiring us to do exactly the wrong thing at exactly the wrong time. But on the heels of the worst-ever year opening for stocks — down 6 percent for the S&P 500, 6.2 percent for the Dow Jones Industrial Average and 7.3 percent for last year’s super-star, the NASDAQ — investors are understandably nervous.
Behavioral economics studies the effect of the recency of a risky event on subsequent financial behavior. For example, I can tell you where I was and what I was doing during the crash of 1987, the market rout of the third quarter of 1990, the minute the market re-opened after the terrorist attacks in the fall of 2001, and during the market meltdown of 2008. The memory of those difficult markets stands out starkly — particularly the most recent decline. Despite over 30 years of professional and personal investing, I am not immune to that sinking feeling of panic when the market sells off with the kind of vigor we have experienced recently. The only thing that keeps me focused on the long-term is a cursory understanding of behavioral economics and knowledge of the long-term, historical performance of stocks.
Interestingly, I cannot pinpoint where I was or what I was doing during the many market rallies I’ve enjoyed. Like most people, I remember the negative events much more vividly than the pleasant ones. When the market rises, we accept it like we do a safe flight or an automobile performing as expected. When the market declines, we are reminded of the harsh reality — that markets, like airline travel, for example, contain inherent risk that we often take for granted.
But let’s take a look at the facts. Click here for the rest of the article: The Arizona Republic