Why Stock Investors Freak Out

Stock investors who watched the Dow drop by nearly 50% between August of 2008 and March of 2009 were put to the ultimate risk tolerance test. As they saw their retirement dreams dissolve with their account balances, individuals pulled record amounts of money out of equity mutual funds. According to the Investment Company Institute, net equity fund flows were minus $28 billion in January 2009, minus $29 billion in February and minus $25 billion in March. A lot of equity investors freaked out during the great recession. And they paid for it big time.

Much of this money flowed into money market funds. An investor who freaked out and sold $100 in stock in early March 2009 would have earned about a dollar on her money market investments by the summer of 2013. The patient investors saw their stock investment climb to about $244.

This is a boon for those of us who study investor decisions, but it was a nightmare for many advisors and their clients. The great equity market freak-out of 2008-2009 battered the accounts of weak-stomached investors. More resolute investors survived the crisis unscathed. So who bailed and who sailed through the storm? New research provides some surprising insights into which clients might be most likely to stick with their investment plan.

It’s hard to anticipate who will abandon their asset allocation policy during a recession. One way is to ask potential clients a battery of risk-related questions. These risk-tolerance assessment tools are a great way to both get the client thinking about the meaning of investment risk and also begin to assess how much volatility they can bear. Texas Tech graduate student Michael Guillemette and I looked at how questions from a commonly used risk tolerance questionnaire predicted whether someone shifted investments to cash during the Great Recession.

We find that questions that measure loss aversion are good predictors of cashing out stock investments. Examples include whether someone focuses on the possible losses or the potential gains from a risky opportunity. If you dwell on the negative, you tend to react badly when your fears are realized. Loss aversion is different from risk aversion because it predicts that investors will overweight losses (seriously—Daniel Kahneman won a Nobel Prize for, in part, pointing out that people really don’t like to lose money). An even better predictor was simply asking people how much risk they’ve taken with investments in the past. General questions about things like salary risk didn’t do a great job of predicting response to a bear market.

Even though risk tolerance questions do predict actual behavior, they’re not perfect. Many clients who say they understand that equity investing involves potentially losing money aren’t as brave when the losses start getting real. According to Texas Tech neuroscience expert Russell James, this is because who we are when we project our risk tolerance is different than who we are when faced with losses in the present.

“A common behavioral bias is referred to as projection bias,” says James. “When you are in a rational ‘cold’ state, you plan for the future as if you will always be in a ‘cold’ state.” When we make decisions in the present, we’re using the rational prefrontal cortex. But when we experience a loss, we tend to use a part of the brain associated with emotion. Since we make decisions about how we will act in the future with a different part of the brain than the one we use when we experience a loss, it’s hard to project how our emotional, irrational brain is going to respond.

A client guessing how she will behave when her portfolio takes a dive believes she will be rational in the future. But when the future comes and things start getting scary, emotions kick in. According to James, “when investors actually start seeing their accounts losing massive dollars in a downturn, this triggers the ‘hot’ state emotions.” And when the emotional part of the brain starts firing up, it can take over.

In order to withstand the heat, we have to tamp down our emotions with reason. This can get easier after we’ve experienced a few bear markets and subsequent recoveries. One might expect that more experienced investors will do a better job of talking themselves down from the ledge. This is exactly what we find when we investigate who shifted their money out of equities during the great recession.

A new study by East Central University professor Chris Browning and me looks at how households over age 55 shifted their portfolios between 2008 and 2010. After correcting for equity market movements, we find that, on average, stock investors in this age group decreased the equity share of their investment portfolio by 12%. This is a particularly important group, since equity ownership is actually much higher among those over 65—mainly because they have more wealth in general.