Inflation, Market Volatility and Your Mind

This Morningstar‡ report was first published on August 2, 2022.

As if investors needed any more calamities to deal with, rising inflation, market volatility, and recession scares have been dominating headlines and our wallets.

During times like these, many investors may feel the need to understand these occurrences and the immediate impact they can have on their finances, and there are plenty of resources to help navigate this ever-evolving situation. However, as we all devour every article with the word “recession" in the title or watch every drop and rise in the market, it is important to acknowledge our biases.

Our minds tend to take shortcuts when making decisions, some of which lead us to the wrong conclusions and actions. These shortcuts may sound harmless, but they can have a drastic impact on our finances. To make things worse, today's current market environment can further exacerbate our biases, making them even more dangerous.

Our Biases Can Make Things Worse

Our biases can arise at any time, but given today's market environment, a few especially harmful biases can be scarcity mindset, action bias and loss aversion.

Scarcity Mindset

A scarcity mindset occurs when we feel like we have less than we need, whether that be insufficient money, time, food, social connections, or other essentials. This feeling can prompt us to make decisions we can later regret, which can then snowball, where one bad decision made under pressure can set up the stage for another. In fact, research has found that scarcity can impact our neural mechanisms when making decisions, decreasing activity in the part of the brain that plays a role in goal-directed decision-making. Given today's higher prices, many of us may be starting to feel the pinch in our wallets and find ourselves exhibiting a scarcity mindset.

Action Bias

“Well, at least you tried." This common consolation can be comforting and justified in many decisions, but not all. In some situations, it can actually be better to do nothing at all. The problem is that our minds want to take action. In our minds, it hurts less to try something and lose, compared with doing nothing and losing anyway. During times of market volatility, if investors don't calmly think about the appropriate course of action and give in to action bias, it can make losses objectively worse despite feeling subjectively better.

Loss Aversion

One of the most well-known and often-cited behavioral biases, loss aversion, can be especially prevalent during market volatility. Specifically, a 10% portfolio loss feels more intense than a 10% gain for many investors because we are loss-averse: Experiencing a loss generally feels twice as bad as gaining the same amount feels good. This strong emotional reaction to losses can cloud our judgment during times of volatility.

How to Get Ahead of Our Biases

Unfortunately, our biases are part of what makes us human, and we can't erase them completely, but that does not mean that all hope is lost. The first step to combatting our biases is to understand and acknowledge them. For example, when the market drops and your gut tells you to sell now, take a moment to recognize that emotion is a possible example of action bias. Besides just accepting our biases, here are a few things we can do to make sure they don't wreck our finances:

1) Reframe performance.

Is your financial goal to get the most returns possible? Or is it to have a comfortable retirement or buy a lake house in a few years or save for your 2-year-old child's college costs? For many investors who have already tailored their financial plans to their long-term goals, short-term fluctuations may not be too big of a concern. When considering the performance of your portfolio, keep your long-term goals in mind and not the day-to-day ups and downs of the market.

2) If you need to take action, take thoughtful action.

Instead of trying to suppress the urge to act, a better strategy may be to redirect it. For example, instead of looking to see what losing investment to sell, spend your energy making sure your financial plan is on track to meet your goals. This could involve making sure your portfolio is well diversified or making sure your emergency savings fund is well stocked. Or, if a scarcity mindset is getting the better of you, now may be a good time to do a budget audit to cut down on any unnecessary expenses.

3) Stay connected, but not too connected.

Constant market updates can put anyone on edge, especially during market volatility. It's important to stay connected and up to date on world news, but constant monitoring of media feeds can trigger behavioral biases. There's a line between being an informed investor and obsessing over every market movement and, especially during times of market volatility, this line can become more and more blurred. Try setting up a regular schedule for how often you check your portfolio or even the market news. And, while you're at it, maybe cut down on the number of news alerts you receive on your phone.

We all know to expect things like market volatility and inflation, but the emotions we feel while they occur can be even more dangerous than market movements themselves. When stress and anxiety are high, it's easy to give into our biases and let them cloud our better judgments.

The interventions above can help us overcome our biases, not do away with them. Using techniques from behavioral science, we can work to prevent biases from derailing financial plans by making it easier to make the right decision when it counts and staying focused on our long-term goals.