Underperformance Driven by Emotional Reactions to News Headlines

Over the 20-year period from 2000 to 2020, individual investors have underperformed the market in every way — from stocks to bonds, from broad indexes to industry sectors, from the U.S. to developed and emerging international markets, according to Nationwide Financial.

The underperformance can largely be attributed to frequent trading and short holding periods, driven by emotional reactions to news headlines that may drive individuals to make irrational investment decisions.

Headline-driven emotional investing has increased as the amount of information available has exponentially grown over the last few decades. Now more than ever before, investors must rely on their judgement to assess what is meaningful and what is simply a distraction.

Economic news will play to an investor’s emotional response, but political or international events can also sway investor sentiment as well, according to Nationwide.

Emotional investing is a real psychological response; the amygdala, the part of the brain that regulates emotion, is also used for decision making. In stressful situations, emotions can take over the amygdala and influence decision-making processes, which may lead to irrational investment decisions.

These impulsive and irrational investment decisions that lead to poor performance can often be connected to market timing. 

According to Nationwide, individual investors tend to trade frequently and hold investments for short-term periods, shorter than the length of the average market cycle. These investors buy high and sell low — the exact opposite of what they should do, according to basic investment principles.

This poor timing and movement in and out of the market means that investors will often miss the best days in the market. Missing those days can significantly reduce the returns that investors achieve, and ultimately cost real money relative to the outcomes that investors who remain fully invested would achieve, according to Nationwide.

Historical results from the financial markets can also show investors the value of maintaining a long-term perspective and help them downplay the influence of short-term performance.

Looking at returns for the S&P 500 back to 1929 shows how the probability of positive returns increases with the length of the period. Negative returns are more likely for shorter periods — nearly every other day in the market is a down day, according to historical S&P 500 data. Even on an annual basis, one in every three years is negative. But over longer periods, 10 years and beyond, the probability of negative returns declines dramatically.

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