Haunted Houses and Behavioral Finance

Note: This piece originally appeared on the blog of Modern Financial Planning in 2018

One of the design characteristics of being human is that we run from fear and protect ourselves from danger. Whether it’s an animal in the woods, or a scary dark room, an emotional response goes off in our brain - to run, to protect.

In fact, the word emotion stems from the Latin root meaning “to move away.”

Before imagining ourselves acting in certain ways in hypothetical situations, we need to understand what it means to be human and the design “flaws” we have.

It is October, and Halloween is approaching. That means it is haunted house season.

We know that haunted houses are not real. We know that things are going to jump out of dark places. We know almost exactly how it is going to play out. But we still get scared.

There are countless examples of situations like this (scary movies, dark rooms, etc.) where we know the outcome, or know the situation, yet we still react a certain way. Fortunately or unfortunately, depending on the situation, this is by design.

Knowing something is one thing, acting human is another.

This is how behavioral finance works.

If an advisor asks clients about how they will respond to a hypothetical 30% drop in their portfolio, many times they may get the “right” answer.

“I will stay the course and not react.”

“I will continue adding to my portfolio.”

The reality is, this is not how most humans respond. This isn’t how we are designed to respond.

Responding properly to the hypothetical is only the first line of defense. A large number of investors will not actually act this way when the 30% drop comes because it is much easier said than done.

Most people couldn’t imagine sitting through the scariest of movies and not flinching. But we do imagine ourselves having zero reaction to a market crash.

Markets go up and markets go down. They always will. We know this.

However, when markets fall, it isn’t just a percentage or dollar issue.

Every news headline is negative, every social media post is negative, thousands of “experts” are calling for the end of the world as we know it. There are other factors too - interest rates, inflation, layoffs, and pandemics.

Fear sells, and during market turbulence this fear selling happens for days, weeks and months on end. All of this noise penetrates well beyond our first line of defense and gets to our 2nd, 3rd, and 4th layers of defense.

When all of your friends, neighbors, and co-workers are telling you to sell. Or telling you that they sold everything last week and that you should too. This gets to our 5th and 6th layers of defense.

We know that reacting during a volatile or falling stock market is not likely to turn out well, but sometimes we cannot resist the urge to do what we’re designed to do - to do something.

Would we rather be disciplined, alone, and potentially wrong? Or would we rather be with the crowd, and potentially wrong? Human history and tribalism show our preference is the latter.

How hard would it be to do nothing?

How many layers of defense do you have?

After all, we’re only human.