a day ago
When stock markets turn ugly, these four tricks will help prevent knee-jerk reactions
On April 4, the S&P/TSX Composite Index fell almost 5 per cent. While some investors hammered the sell button, others went on with their day and made no changes to their portfolios.
Same red numbers, two opposite reactions. Why?
Behavioural science says big losses should, in theory, jolt us out of knee-jerk habits and push us into careful 'System 2 thinking' – a term psychologist Daniel Kahneman used to describe our deliberate reasoning, analytical mode. 'System 1' is its opposite: fast, automatic, fuelled by emotion and mental shortcuts.
System 2 is reflective, methodical, the part that double-checks math homework and rereads contracts. The trick is getting the brain to shift gears from the first to the second when markets turn ugly.
New research published in the Judgment and Decision Making journal offers a clue. Experiments found that financial losses prompt people to spend more time thinking and to make better, more deliberative decisions – but only when there is enough time and cognitive space to think.
Add a tight deadline, or the perception of a time pressure, and the benefit disappears: participants flip back to snap (System 1) judgments.
The authors paid volunteers to solve brain-teaser questions. Get one right, earn 25 cents in one series of questions. Get it wrong, lose 25 cents in another series. When a potential loss was on the line, subjects spent more time thinking and arrived at more correct answers. That's evidence that the sting of loss can summon System 2.
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Then the experimenters imposed a 20-second countdown clock. Under the gun, performance tanked and participants defaulted to the fast, intuitive – and often wrong – answer. Losses can prompt deep thinking or blind panic. What decides the outcome is whether the brain is given breathing room.
Now bring that insight to Bay Street. Markets embed their own stopwatch: price quotes refresh almost instantly and social feeds stir up emotions around the clock. Investors do not merely sense urgency: both mainstream and social media revolve around it.
Worse, the clock never stops. Extended-hours trading sessions for Canadian investors are already available from 4 a.m. to 8 p.m. ET for many stocks, and overnight trading (8 p.m. to 4 a.m. ET the next morning) effectively makes stock trading available around the clock. Given that cryptoasset trading has no market close, maybe the move to around-the-clock security trading is inevitable.
But while retail platforms tout overnight access as empowerment, the side effect is obvious: we have lost the natural curfew the closing bell once provided. Instead of cooling off overnight, a jittery investor can unload shares at 3 a.m., when liquidity might be thin and fear might be thick.
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In contrast, regulators and exchanges recognize the need for oxygen. Market 'circuit breakers' halt stock market trading after big losses occur in a single trading session. These engineered breathing spaces give market participants time to digest what is happening.
The implication for investors is obvious: while market losses can jolt us into deeper, more careful reasoning, this benefit is only realized if we have the time and mental space to reflect.
In fast-moving markets, or when pressured to make quick decisions, the advantage of loss-induced deliberation may be lost so we need to figure out how to buy time or avoid reflexive decision-making.
Here are four practical defence strategies that could help:
1. Write an investment policy statement before you need it. Even a one-page policy, drafted when you are calm, acts as a lighthouse when seas get rough.
2. Automate what you can. Prescheduled contributions and auto-rebalancing reduce decision points.
3. Use a checklist buddy. Talk decisions through with an adviser or trusted friend. Saying it out loud acts as a speed bump against emotion.
4. Respect the bell (even if markets ignore it). For investors that day-trade, decide in advance that you will not place trades outside regular hours unless a preset rule demands it. Sleep, like diversification, can be free risk management.
I'm probably guilty of banging the drum on this but investors should remember that platforms hungry for order flow wave the 'democratization is good for all investors' flag proudly. But more access is not synonymous with better outcomes. Investors need to keep their eyes open.
When markets nosedive, the colour red is not the true enemy – the alarmism and perceived time crunch is. Give your brain a little oxygen or adopt systems to avoid reflexive responses and the same loss that might have provoked a panicked sale might be avoided.
Sometimes the smartest trade is no trade at all and the best circuit breakers may be the ones you install for yourself.
Preet Banerjee is a consultant to the wealth management industry with a focus on commercial applications of behavioural finance research.
