The scene
The scene
Eric watched the market drop 15 percent over six weeks. He kept saying he was a long-term investor. But the red numbers every morning got harder to ignore.
He sold. The plan was simple, or it felt simple. Wait for the bottom. Buy back in when things stabilise.
Three weeks later, the market started recovering. Eric watched. Up 4 percent. Then 8. Then 12. He kept waiting for the "real" bottom that he was now sure had not arrived. By week eight, the market was 22 percent above where he had sold.
Eric got back in eventually, at a higher price than he had sold. The "safer" decision had cost him a 22 percent gain he never collected.
He is not unusual. Behavioural finance research has documented this pattern across decades and markets. Investors who try to time the market consistently tend to underperform investors who stay invested through volatility, on average and over long periods.
What your brain just did
What your brain just did
Our minds weight losses about twice as heavily as gains of the same size, so we will give up future gains to stop current pain. Eric is not panicky. His brain ran the standard loss-aversion calculation that all our brains run when watching something we own lose value, the way all our brains do when a paper loss starts to feel like a real one. This behaviour has a name: Loss Aversion.
What to do instead, in one move
What to do instead, in one move
The behavioural research is consistent on this. Investors who decide on an asset allocation in advance and hold it through volatility have historically outperformed investors who try to time entry and exit. This is not a recommendation to do anything specific with your money. It is a pattern documented by decades of academic research that anyone can read and consider for their own situation, ideally with input from a licensed adviser in their country.
TL;DR
- Situation: The market drops. You feel pressure to step out and wait for safer ground.
- What your mind does: It weights the visible loss more heavily than the invisible cost of missing the recovery (this is called Loss Aversion, see below).
- Consequence: Decades of behavioural finance research show that investors who try to time the market consistently tend to underperform investors who stay invested through volatility.
- What to do: Many investors who follow research-based approaches set their asset allocation in advance and hold it through volatility, rather than reacting to short-term moves.
What to do
- Many investors set their asset allocation in advance, based on their time horizon and risk tolerance, and avoid changing it in response to short-term moves.
- A common practice among long-term investors is to write down the conditions under which they would actually sell. If the current move does not meet those conditions, no action is taken.
- Some people remove the daily price information entirely during volatile periods, checking only quarterly to avoid emotional decisions.
- For larger portfolios or complex situations, many people consult a licensed financial adviser in their country before making changes during volatile periods.
What not to do
- Do not sell because the market is dropping. Market drops are a feature of long-term returns, not a defect.
- Do not assume you can identify the bottom. The bottom is only visible in hindsight, by which point the recovery has usually started.
- Do not confuse "doing something" with "doing something useful". Action that feels protective often costs more than patience that feels passive.
The market does not announce the bottom. By the time it feels safe to come back, the gain you stepped out for is already in someone else's portfolio.
Want to understand why this happens?
Loss Aversion is the brain's tendency to weight losses about twice as heavily as gains of the same size.
When Eric saw his portfolio drop 15 percent, the felt pain of that loss was roughly twice the felt joy of the gains he had on the way up. The brain reaches for a way to stop the pain. Selling stops the pain immediately. That the selling locks in the loss and removes future gains is invisible in the moment.
It is not you. It is how every human brain handles unrealised losses.
What the research found
Kahneman and Tversky's 1979 paper Prospect Theory documented that people weight losses about twice as heavily as gains of the same size. This asymmetry has been one of the most replicated findings in behavioural economics, documented across decades of experiments in multiple countries.
Applied to investing, the asymmetry produces a predictable pattern. Investors hold winning positions too short (to lock in gains and avoid the pain of giving them back) and sell losing positions too early (to stop the pain of further drops). The combined effect, documented in studies of individual investors by researchers like Barber and Odean, has historically been worse returns than buy-and-hold investing over long periods.
"Losses loom larger than gains. The pain of losing something we own is roughly twice as strong as the pleasure of gaining the same thing." — Daniel Kahneman and Amos Tversky (paraphrased from Prospect Theory, 1979)
This is called Loss Aversion. Daniel Kahneman and Amos Tversky, Prospect Theory: An Analysis of Decision under Risk (1979).
Get the next pattern before it gets you.
Get free weekly patterns explained in 60 seconds.
Free forever · Unsubscribe anytime
Related decisions
I have been saving these loyalty points for two years. The trip I wanted now costs 50 percent more points than when I started.
Behind this pattern: Endowment Effect (Daniel Kahneman, Thinking, Fast and Slow (2011)).
The annual plan said save 30 percent. I clicked annual. I cancelled three months in.
Behind this pattern: Hyperbolic Discounting (Dan Ariely, Predictably Irrational (2008)).
I have been meaning to set up automatic savings for two years.
Behind this pattern: Present Bias (Richard Thaler & Cass Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness (2008)).
I moved $5,000 to a 0 percent card. I planned to clear it before the promo ended. I did not.
Behind this pattern: Planning Fallacy (Daniel Kahneman & Amos Tversky, Intuitive Prediction: Biases and Corrective Procedures (1979)).