Investor Behavior in Downturns

Contents

1. What the twenty year study measured
2. Loss aversion
3. Herd behavior and the information problem
4. The test of 2007 to 2009
5. How Omaha remembered it
6. The retreat from risk
7. The new frugality
8. The repeat in 2020
9. Why the reasons are not about intelligence
10. What comes next for it

Brent O’Mara took from his early years the knowledge that markets do not always cooperate. The question readers bring to this entry is a plain one: why capable people sell near the bottom and buy near the top. Decades of research describe the same handful of mistakes, and the explanations researchers give have little to do with intelligence. A certified financial planner writing for The New York Times in 2010 put it in terms of wiring: people are built to acquire more of what gives pleasure, which means buying what has risen, and to be rid of what causes pain, which means selling what has fallen.¹ He added that people trade, watch financial television and listen to commentators shout, despite knowing better.¹

What the twenty year study measured

Every year the research firm Dalbar compares what the average equity investor actually earned with what a broad market measure earned over the same period. The 2010 column reported the study covering the twenty years to December 31, 2009, and the gap between the two was wide: an investor who had simply put money into a fund tracking the measure and left it alone would have done far better than the average investor who traded in and out.¹ What struck the author most was how little the gap changed from year to year. The tendency to behave badly, he wrote, was not going away, and the only hope of closing the gap over the next twenty years lay in attending to behavior rather than to the market.¹

Loss aversion

Behavioral finance gives the tendency a name. A contributing adviser writing for Kiplinger in 2025 described loss aversion as the finding that losses are psychologically about twice as powerful as gains, strong enough to make seasoned investors act against their own plans.² When volatility spikes, the instinct to cut losses overrides the long term strategy, producing poorly timed exits that lock in the loss and miss the recovery that follows.²

Figure

A checklist before a major change

1. 01
   AdmitAcknowledge the tendency to buy what has risen and sell what has fallen, and look honestly at past decisions.
2. 02
   WaitWrite the proposed change down and let it sit for 24 hours, or explain it aloud to a trusted friend or adviser.
3. 03
   DeclineRecognize that staying out of the market altogether is a legitimate choice for some people.

Herd behavior and the information problem

The same piece made a point that cuts against intuition. More information does not solve the problem and can make it worse, because real time market data and instant access to a personal account make people more sensitive to every short term movement and open the door to unwise decisions.² Fear and herd behavior, the adviser wrote, lead investors to act impulsively in downturns, prioritizing short term survival over the strategy they set in calmer times, and the habits that help are unglamorous: checking the account less often, revisiting goals rather than news, and staying diversified.² Human beings, the column began, are afraid of what they do not know, and the innate response to uncertainty often overrides logic no matter how much historical data is put in front of them.²

The test of 2007 to 2009

The sharpest modern test came when equity prices fell 57 percent between October 9, 2007 and March 9, 2009. Alicia Munnell of the Center for Retirement Research noted in 2011 that most of those losses fell on the retirement accounts of the oldest boomers, who were approaching retirement with the largest balances, while those already retired relied more on traditional pensions and younger workers had not yet accumulated much.⁴ Her larger finding was that the market had treated that older cohort well over a working lifetime despite the collapse, because they had built their balances during the long rising market from 1982 to 2000, while later cohorts had been hit by two collapses without the benefit of that run.⁴ Her conclusion was that the generations behind the boomers would have to save more to end up as well off, which is a statement about behavior rather than about markets.⁴ The fuller account of the episode is under the financial crisis.

Figure

The decline of 2007 to 2009

fall in equity prices from October 9, 2007 to March 9, 2009

57 percent

length of that decline from peak to trough

17 months

the long rising market during which the oldest boomers built their balances

1982 to 2000

How Omaha remembered it

When the pandemic recession arrived in 2020, KMTV in Omaha asked people who had lived through 2008 what they had learned. One resident said 2008 had been the hardest, because whatever investment a person had, it went away, and that he had refinanced his house at a low rate the second time around.⁶ Ernie Goss, the Creighton economist, called the new recession the deepest downturn since the 1930s and said it was no time to panic, that measured approaches were called for even where a person had to move quickly.⁶

The retreat from risk

Behavior changes after a downturn as well as during one. Ten years after the failure of a large investment bank exposed how cavalier the world had been toward risk, with households buying homes they believed could never fall in price and banks making loans they believed would never default, Greg Ip of The Wall Street Journal described a retreat that reshaped institutions, regulations and attitudes, and with them the economy: growth that was durable but muted, with less of the risk taking that drives both booms and busts.³ Risk taking never disappears, he argued; it changes shape, often to slip past the defenses built after the last crisis.³

The new frugality

Pew Research measured the household version of that retreat in May 2010. Thirty months after the downturn began, Americans had lowered what they expected from retirement and from their children’s prospects and had turned frugal, spending and borrowing less, saving more and paying down mortgages sharply.⁵ Fifty five percent of working adults reported some job related hardship over the period.⁵ The survey also found an oddity: some of the groups hit hardest were the most optimistic about recovery, and 62 percent of respondents expected their own finances to improve within a year.⁵

The repeat in 2020

The Center for Retirement Research saw the pattern again in March 2020. Some boomers who lacked pensions and had fallen behind on saving had tried in the preceding years to catch up with riskier portfolios in a rising market, and they were now experiencing the downside of that risk; planners worried most about panic decisions, such as selling out of stocks after a steep fall or claiming Social Security at 62 and locking in a permanently smaller check.⁷ One planner conceded that for a laid off couple with far more expenses than income, claiming early was not irrational so much as desperate.⁷

Figure

Two recessions as Omaha saw them

	2008 to 2009	2020
Cause	a housing and financial collapse	a pandemic that emptied restaurants, hotels and events
What people lost	money, homes, retirement funds and jobs	jobs and income as businesses closed
Length	18 months	projected at about nine months when the station reported in June 2020
The economist's advice		no time to panic, take measured approaches

Why the reasons are not about intelligence

Nothing in this research says the people who sold were foolish. The 2010 columnist listed the questions readers might ask themselves, whether they had been caught up in the technology mania of 1999, in housing in 2006, or had sold in 2002, late 2007 or early 2008, and offered the checklist that pilots and doctors use as the remedy, because the problem is a reflex rather than a reasoning error.¹ The Kiplinger adviser reached the same place from the other side: no quantity of historical data, expert opinion or analytics put in front of a person reliably overrides the innate response to uncertainty.²

What comes next for it

The research keeps measuring. Dalbar repeats its study annually, Pew returned to its survey panel, and the Center for Retirement Research has argued that the only immediate help for younger cohorts is to extend automatic enrollment and automatic escalation of contributions to existing workers as well as new hires, so that the saving happens without a decision at all.¹⁴ The next hard year will produce the next data set, and the pattern it records is unlikely to be new.