The short answer for Bernie Scozzafava, Diversified Fixed Income Portfolio Manager, and Dan Codreanu, Senior Diversified Fixed Income Quantitative Analyst at Eaton Vance, is that it’s human nature, irrational though it may be in many cases:
- Loss aversion: Behavioral finance tells us that fear trumps greed. In other words, most investors dread losses more than they desire gains.
- Recency bias: Recent events trigger hasty decisions, even when such events contradict longer-term trends or investment objectives.
- Overreaction bias: Most investors place too much emphasis on negative, sensational news headlines, leading to indiscriminate selling.
- Herd behavior: Investors take an “everyone is selling” mentality and follow suit because they fear being the last one to sell.
According to Eaton Vance experts, these all-too human tendencies were exacerbated by the 2008 credit crisis, which left many investors permanently scarred. This debacle, caused by massive losses on subprime loans, sparked the worst market collapse in more than 75 years. Although nearly eight years have passed since then, the carnage still remains fresh in investors’ minds, with many fearing that the next recession and market downturn will be just as bad.
“More often than not, such fears are unfounded. For example, there is growing concern (and press coverage) these days that bank loans to the energy sector could pose a serious threat to the economy and financial system – even though banks generally do not have excessive E&P exposure, are better capitalized and adhere to stricter counterparty risk measures than they did prior to the 2008 crisis”, point out Scozzafava and Codreanu.
Investors with long time horizons are best positioned to tolerate market volatility and earn attractive returns over time, but instead, many behave irrationally and sell during corrections to limit their short-term losses.
“Market volatility and corrections are many investors’ biggest fear. However, we believe a bigger fear should be missing out on the market recoveries that typically follow the corrections. Our research shows that when disciplined, data-driven investing gives way to biased, emotion-driven investing, portfolio performance suffers”, conclude.