To say the least, financial markets were gut-wrenching for investors in 2011. An earthquake and tsunami in Japan, revolutions in the Middle East and North Africa, and unparalleled challenges to the Eurozone rattled nearly all asset classes and strained investor resolve. But the market volatility we witnessed in 2011 was relatively minor compared to what occurred in late 2008. As a result of these global shakeups, and those of the preceding decade, investors are unsettled about their investment practices, and are reacting to the unwelcome effects volatility can have on their emotions and investment returns.
What has been the psychological impact on investors across multiple generations during these bouts of volatility? And, why are investment strategies and risk tolerances so different from one generation to the next?
Function of age on risk tolerance
Investor reaction to two of the worst bear markets for stocks since the Great Depression is partly explained by age, according to a recent study conducted by the Investment Company Institute (ICI) and the Federal Reserve Board. It found only 22 percent of households headed by someone younger than 35 in 2010 were willing to take above-average or substantial investment risk, compared with 30 percent of such households in 1998.
Reduction in risk appetite is generally happening across the board, but most notably in the Generation Y cohort (investors younger than 35) — just when the need for higher returns is most urgent.
Investors who are now 50 to 60 years old were part of a great bull market that lasted 20 years. They made money in the markets through stock investments that rewarded them for taking risks. We now have Generations X (generally those ages 35-50) and Y who have never been actually rewarded for taking equity risk. As a result, we may have an unintended consequence of a large group of younger, risk-averse investors moving away from stocks at a time when most need the higher returns available from a healthy exposure to stocks over the long term. Increased tendencies toward loss aversion could cause many young investors to miss out on the returns necessary to meet their long-term financial goals.
Investment options for younger investors
A potential solution, especially for younger investors who may have watched their parents’ portfolios take a hit in recent years, could be taking small steps and gradually diversifying away from heavier bond or cash holdings and into stocks. Young investors may also find that company-sponsored retirement plans ― regarded by most workers as a pillar of financial security in later life ― offer gradual immersion into potentially more rewarding assets. More importantly, investors of all ages need to establish a clear and thoughtful financial plan that matches asset allocation to their objectives, time horizon and risk tolerance. A well-designed asset allocation strategy, implemented with thoughtful rebalancing, will allow investors to benefit from volatility.
Keeping emotions in check
Investors of any age who understand volatility are more likely to manage their portfolios with confidence and make effective decisions.
Volatility causes emotional distress, and that emotion can get in the way of making effective decisions about strategic asset allocation, which is one of the most important components of investment decision-making.
So what, then, can investors do to temper their emotions? Part of the answer lies in being able to acknowledge that human behavior has many layers. There are complex psychological reasons at play.
Human nature teaches us that fear is a powerful emotion and tends to overrule our rationality. Thus, in the case of extreme market volatility, investors will move in sync away from risk and toward safety. When they perceive that it is safe to get back into the market, investors get back in together, bidding up asset classes. These up-and-down market movements continue until economic conditions return to normal, or when someone or something steps in to restore order.
The key for investors is to separate the events in their lives from how they feel about their financial situation. Without drawing this distinction, emotions may lead investors to buy at the top and sell at the bottom. A professional advisor can be instrumental in helping investors create a financial plan that will allow them to better manage the emotional stress that comes with volatility. Additionally, investors need to recognize the importance of strategic asset allocation, remaining flexible in the face of rapidly shifting markets, and thoughtfully rebalancing portfolios during periods of market stress.