During times of economic uncertainty and market volatility, it’s only natural to have questions and concerns.
When dealing with things like pandemics, natural disasters, or other unplanned-for circumstances, the health of the public is obviously top priority. But you may also have concerns about how it will affect your investments and financial plans.
The current COVID-19 pandemic is one such situation, as it’s turned global markets upside down.
Eric Freedman, Chief Investment Officer for U.S. Bank Wealth Management, discusses three different stages of investor behavior that can occur with market uncertainty. Though all investors won’t go through each of the three stages, they represent a general timeline of common actions people take. Some investors go immediately into a later stage, while others start at — and remain — in the earlier phases.
Understanding these stages may help you better process the news surrounding market volatility.
Three stages of investor behavior during uncertain times
Stage 1: Reactionary
Once a news story emerges, some investors feel the need to take immediate action, either buying or selling without engaging in deep analysis. Their time horizon, investment style, or patience level may be short, and their reaction time follows that.
With the advent of algorithmic and program trading, where more investors rely on formula and rules-based momentum strategies, the reactionary stage in events of uncertainty can be drawn out.
Currently, there are new virus-related developments emerging continually from all areas of the globe. Some investors may get stuck in this phase because they are reacting to ever-changing information.
Stage 2: Liquidity
This stage is distinct from the reactionary stage in that certain investors are forced to sell assets.
For example, at some investment firms, portfolio managers purchase or sell securities on margin (a specific loan to purchase securities). Margin lenders have strict rules about when a margin borrower must either exit their position or post more collateral (typically, additional cash or securities deposits). If there’s no more collateral to post, a portfolio manager is forced to liquidate that position.
In an environment of uncertainty, where volatile prices may trip margin and risk boundaries, selling can trigger more selling. Eventually, markets clear and the selling subsides, but prices tend to drive the investment decisions.
Stage 3: Fundamental
This stage is shaped by investors who wait to make investment decisions based on the longer-term implications of a given event.
These investors will sacrifice speed for analysis; they pay attention to price, but typically price will not drive their buy or sell decisions unless extreme price swings emerge. Their views may be shaped by ongoing event updates, but more fundamentally-driven investors tend to make buy or sell decisions after the proverbial dust settles.
4 steps you can take when the market is volatile
In these times of uncertainty, what are some concrete financial actions you can take? Freedman outlines what investors should consider during market volatility.
- Review your financial plan. Start by engaging with your financial professional. “Find out if you’re still comfortable with your existing plan,” says Freedman, “and if you don’t have one, use this time to establish one.”
- Examine your personal tolerance for risk. While no one likes seeing prices move against them, if the current market downturn is particularly difficult to stomach, talk with your financial professional about your ability to tolerate risk, and perhaps revisit the mix of investments in your portfolio that support your pursuit of financial goals.
- Assess your fixed income allocation. Freedman explains that “bonds provide two functions in an investor’s portfolio: current income for cash flow needs and the ability to mitigate capital market volatility.” Government and high-quality bonds may help safeguard your portfolio from risk.
- Think about timing. You can always shift assets and move to cash, but that requires two decisions: when to sell and when to buy back. “Countless academic and behavioral studies reveal how difficult that timing can be and how harmful it can be to your long-term investment plan,” says Freedman. “Your financial professional can talk through asset classes and tools that could dampen the volatility you may be experiencing within your overall portfolio.”
In times of market uncertainty, like our current global situation, take a moment to pause and consider what investor psychology stage you’re in. Market volatility is inevitable but discussing your options with a financial professional can help you make the most clear-headed choices possible.