When confronted by danger, most of us run away. Tim Bennett explains how this very human reflex can damage your investing returns.
Why investors shouldn’t watch prices when stock markets fall
Why is it that so many investors do precisely the opposite of what they should? We often buy when markets rise and sell when they fall i.e. we buy high and sell low, when we should be doing the polar opposite. A recent paper proposes an answer to half of this conundrum – we are programed to overreact to the colour red when markets fall. In doing so, we damage our long-term returns.
What goes wrong?
When prices fall, they are usually shown in red on our TV and computer screens. And whilst you may think “so what?” this may in fact be more of a problem than we think.
Some recent research in this area suggests that our reaction to the colour red is pronounced and has both biological and programmed origins – it is a result of nature and nurture. If that is true, then seeing the colour red too often may actually be harmful to your wealth as it triggers a powerful “flight” reflex over which we have little control.
Isn’t this nonsense in a rational market?
Traditional financial theory would say that such a supposition – that investor behaviour can be influenced by colour – is madness. Rational human investors surely shouldn’t change their behaviour just because a price is shown in a particular hue?
However a body of biological and psychological research suggests otherwise.
Why the colour red may matter
The paper mentioned above puts forward the idea that seeing the colour red too often triggers our flight reflex and actually alters both our attitude to risk, at least in the short term and our willingness to invest subsequently. What’s more, this can be measured and quantified.
The danger is that if we do indeed get panicked into selling by simply seeing the colour red on our screens too often, we need to take steps to counter what could be a damaging reflex. The reason it is costly to bail out of stocks as they are falling fastest is that the best investing days tend to follow immediately after the worst – miss those and your long-term returns can be seriously dented, according to data from JP Morgan on the second slide below.
To paraphrase a famous 1970’s children’s’ program, when markets start to fall “why don’t you just switch of your television and go and do something else instead?” For today’s investors, who are bombarded with sell signals, particularly when markets are volatile, it remains sound advice.