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How your subconscious responds to market changes
Dealing with changes on the financial market is complex. Learn about behaviors such as the conservatism or disposition effect and get to know the psychological tricks that will help you in uncertain times.
The main points in a nutshell
The main points in a nutshell
- Investing on the financial markets means being exposed to constant change.
- Dealing with uncertainty is not always easy and can cause investors to act hastily or impetuously.
- Three distinct phenomena known as the conservatism, anchor and disposition effects may be behind these behavioral patterns.
- Test your knowledge at the end of the article.
As the Greek philosopher Heraclitus said: “Nothing is as constant as change.” This is particularly true of financial markets, where prices rise and fall every day. Unconscious behavioral tendencies, also called biases, cause us to react to changes on the market in certain ways. We will explain three of these tendencies in more detail to help you better understand your own behavior in the event of price fluctuations and make more well-informed, objective decisions.
The tendency to conservatism: once good, always good?
The tendency to conservatism: once good, always good?
When faced with a new decision, we tend to rely on information gained from previous decisions and to neglect new information. This, at least, is what conservatism bias says.
The challenge here is that those who stick to their previous knowledge and do not expand it with new insights will not be able to make well-founded decisions in the event of changes. Investors who display this behavioral tendency tend to invest more conservatively and react too slowly to trends on the financial market.
Imagine the following example: You invest in a company that specializes in reducing the CO2 in the earth’s atmosphere by absorbing greenhouse gases. Right now, this technology is new and unique. In ten years’ time, however, a competitor could become much more established. In a worst-case scenario, failure to stay informed could mean you miss the boat. Due to outdated information, investors may be tempted to hold onto their original investment and not sell it at the crucial moment.
This conservative behavior can be traced back to the early days of humankind when people survived by repeating previous behavior. Today, the world is a much more dynamic place where repetitive patterns of behavior are often not effective, especially in volatile financial markets.
Tips:
Tips:
- Stay proactively informed about financial markets and trends.
- Talk to your bank advisor about changes on the market.
- Review various investment solutions as part of your investment strategy and risk profile – we will be happy to help you.
Pay attention to the anchor effect
Pay attention to the anchor effect
Anyone who orders something from an online shop will be familiar with the following example. There are two identical products: the first was originally priced at CHF 50 but is now on sale at CHF 20. The second product is still at the original price of CHF 20. Which product would you rather buy?
Although both products cost the same, most people will probably choose the first one. Why? Because we tend to base our decisions on the first available information. This behavior is known as the anchoring effect.
We subconsciously compare follow-up information with the previous information – it serves as a kind of anchor for comparison.
When applied to the stock market, the anchoring effect causes investors to make decisions based on the initial price of the stock and the fear that its value could drop after purchase. Selling it prematurely might lead to missed opportunities because it would be impossible to benefit from future price rises.
Tips:
Tips:
- Do not rely automatically on the first available information: always consider the bigger picture when making your decision.
- It pays to take the long view, so avoid the temptation to sell at the very first price fall. In the best-case scenario, you will minimize or even avoid a loss when the price recovers later.
- When confronted with several offers for the same product, always question proactively how exactly they differ from one another. Check which product suits your needs better.
Understanding the disposition effect
Understanding the disposition effect
Do you remember when Swissair was grounded? When Switzerland’s national airline went bankrupt in 2001, many investors hoped for better times when they would be rewarded for sticking with the company. They fell prey to what is called the disposition effect.
This effect is particularly evident in an investment context and can be described by the following quote from the two economists Hersh Shefrin and Meir Statman:
Sell winners too early and ride losers too long.
The disposition effect describes a situation in which investors hold shares for too long when the price falls and sell them too soon when the price begins to rise again.
There is, of course, no right or wrong answer when investing because no one can predict what will happen on the market. Depending on the investment strategy, early profit-taking can certainly make sense. However, those hoping for long-term dividend growth with a “buy and hold” strategy will find that selling too quickly can be counterproductive.
The disposition effect is diametrically opposed to the loss aversion bias, according to which investors would sell their stocks immediately. Read more about loss aversion and other psychological biases in the field of behavioral finance in the article “Should I invest? Factors that influence our decision”.
Tips:
Tips:
- Because no one can time the market, you shouldn’t start investing without a plan. Instead, it is advisable to prepare a personal “investment rationale,” i.e., reasons why you invest, on which to base your investment decisions. If these reasons no longer apply, then sell your investment. But if they do, hold on to it.
- Never make your financial decisions in isolation, but always in the context of your overall financial situation and investment strategy.
Before making your next investment, it’s worth thinking back to these three behavioral theories and questioning your own behavior. Try to identify which behavioral tendencies – if any – affect you the most, and try to avoid them.
Test your knowledge
Test your knowledge
Select your answer below and find out how others answered.
Imagine you’re a contestant on a game show. You already have CHF 10,000 “in the bank.” If you stop playing now, you will receive an additional bonus of CHF 5,000. However, the quiz master now offers you a “joker” question. If you answer it correctly, you will receive an additional CHF 10,000. But if your answer is wrong, you will forfeit the bonus of CHF 5,000. You decide to play it safe and go home with CHF 10,000 plus the bonus. Which behavioral tendency have you fallen for?
Monica has long-standing experience investing in different asset classes. For years she has owned shares in a company that trades in fossil fuels. After consulting with her financial advisor, Monica decides to sell them and instead to buy stocks in a company in the photovoltaic industry. What behavioral tendency has Monica resisted?
One of the stocks in your portfolio is losing value and is worth less than its purchase price. You decide to sell it immediately. A few days later, the price rises again and reaches the same high as last year. What behavioral tendency may you have succumbed to by selling?
Because a personal conversation is worth a lot
Because a personal conversation is worth a lot
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