When the storms of change and uncertainty impact markets, behavioral finance experts really get their day in the sun. Behavioral finance is generally defined as the study of the effects of psychology on investors and markets, particularly the study of why investors tend to make emotional and irrational decisions which are often against their own self-interest.* It seems that investors tend to respond to market stress in three ways. Allow me to provide a story to illustrate and identify the three responses.
Having grown up in Tennessee, I am well acquainted with storms. I spent every summer of my childhood on our fifty-foot houseboat which was docked on the Tennessee river. We would often spend several days anchored out on the water tied up with five or six other houseboats. Invariably, a couple times each summer strong storms would come roaring across the river bringing lightning, torrential downpours, gusting winds, and sometimes hail. In the face of the storms, boaters had three choices: stay anchored and hope it holds, run for cover and try to dock your boat, or get out on open water and face the storm.
The choice to burry one’s head and stay anchored almost always resulted in a loosed or broken anchor and strong winds pushing 40’-60’ boats up against the shore. You can imagine the costs. The unwillingness to face their current reality created immense pain for many boaters each summer. Boaters who instead ran for cover did not fare much better. I can still remember the chaos of boats desperately trying to make their way into their various dock slips during these squalls. The sounds of people yelling at one another and fiberglass crunching and shattering as the winds blew them off course and into beams or other boats still resonates in my memory.
Ironically a boat out in open water is a great vehicle for navigating a storm. My father’s method of choice, and I would argue the best way to deal with the storm, was to get out in open water and point the nose of the boat toward the wind. This gave us an opportunity to assess the situation consistently and calmly. If the winds changed direction, we would make slight adjustments and stay focused on keeping the boat balanced against the storm.
Ultimately, we believe this is the appropriate method for dealing with financial storms, as well. Some investors may bury their heads and pretend there isn’t a problem, some may desperately try to get out altogether, but the best way forward is to face the economic storm head-on, making small but meaningful adjustments as the environment changes until the winds subside and calmer market waters emerge.
Eric Puckett
* https://www.kaplanfinancial.com/resources/career-advancement/behavioral-finance
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