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When volatility leads to paralysis, invest more tomorrow

Years after the financial crisis erupted in late 2008, record amounts of cash remain on the sidelines. It’s a symptom of investor paralysis: the reluctance of individuals to re-enter the market, even though it may be in their long-term best interest to do so. To cure it, financial advisors need to help clients overcome two psychological barriers: the fear of loss and the tendency to procrastinate. Invest More Tomorrow is a two-part strategy designed to do just that.

Overcoming loss aversion

By far the most important psychological factor in investor paralysis is loss aversion. When people see the value of their portfolio decline, their intuitive mind reacts negatively, and they experience psychological pain. And, says Richard Thaler of the University of Chicago, “people are even more averse to the prospect of future losses when they have experienced loss in the recent past, as most people did during the 2008 financial crisis.”* Under these circumstances, people become much more reluctant than usual to take risks.

How can this be overcome? By means of what we can call “fuzzy mental accounting.” If an investor were to put all their cash into the market in one single transaction, then that amount of money would become the reference point. Any movement of the market that increased or decreased the value of the investment would then be very easily calculated.

If, however, a client were to invest a specific proportion of his portfolio, say 25 percent, at regular intervals, such as every three months, then there is no readily obvious reference point. There is no single figure against which to measure performance. In which case, loss aversion is much less likely to kick in.

Suppose the investments made in the first entry into the market under this strategy were initially to lose value. The client is likely to say, “Oh, I only invested a small portion of my cash, and now I see an opportunity to buy cheap with my next purchase.” This investment strategy is well known, of course, as dollar cost averaging. But people have now seen that dollar cost averaging can’t protect against losses when the entire market collapses, as it recently did. While they were more willing to try it in the past they are afraid to do so now. They may, however, be willing to contemplate doing it in the future. Which brings us to procrastination, the second barrier to breaking through investor paralysis.

Overcoming procrastination
A financial advisor could ask his/her client if he/she is willing to commit to going into the market at some specific point in the future. Pre-commitment is important, because it is psychologically palatable, and is linked to the desired action actually taking place rather than just a vague promise. If the answer is yes, then the question becomes, “OK, when do you think market conditions will be favorable to take that initial step?” This puts the timing of the strategy in the hands of the client, rather than having it imposed. As a result, the client feels both in control and committed to the agreed-upon action. With a specific answer to that question, the Invest More Tomorrow strategy becomes an informal agreement between financial advisor and client.

Pre-commitment to begin investing at a specific point in the future is the key psychological element here, because it doesn’t trigger the intuitive mind’s aversion to doing what is right today. Procrastination is conquered, and the periodic investment program begins.

Pre-commitment engages the benefit of inertia: it is not a question of whether to buy at that point in time, but rather what to buy. The Invest More Tomorrow strategy is a relatively simple overlay on the existing investment plans financial advisors have worked out with their clients. Its purpose is to overcome investor paralysis so that those plans can go into effect rather than remaining stalled.

Behavioral Finance in Action

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* See Richard Thaler and Eric Johnson, “Gambling with the House Money and Trying to Break Even,” Management Science, vol. 35, no. 6, pp 643-660 (1990).

This material contains the current opinions of the author, which are subject to change without notice. It is not intended to provide tax, legal or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation of any security.
Allianz Global Investors is the asset management arm of Allianz SE. The Center is sponsored by Allianz Global Investors U.S. LLC​, a registered investment adviser, and Allianz Global Investors Distributors LLC, a mutual fund distributor.

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