Dealing With Loss Aversion
The evidence is clear: Selling during market downturns in response to loss aversion endangers long-term returns. Happily, there are strategies that investors can pursue to help them avoid the pitfalls of market timing and emotionally motivated selling.
Dollar-cost averaging (DCA)
DCA is a popular strategy designed to help investors avoid emotional market decisions. Essentially, it involves investing a fixed dollar amount at regular intervals, regardless of market conditions.10 For example, an individual may establish automatic, $1,000 monthly payments to their IRA. Regardless of what happens in the market, that amount will be invested every month.
The advantage of DCA is that it smooths out ups and downs and helps investors buy more when prices are low. That’s because in months when the market is up, the investor will naturally buy fewer shares with their fixed amount and, when the market is down, the investor will buy more shares.11
This strategy mitigates the risk that an individual will make a lump-sum investment at the market peak. For many investors, it also helps manage the emotional ups and downs of the investment process. By committing to a simple, monthly (or quarterly, or biweekly) investment plan, an investor can reduce the element of choice and, therefore, make it easier to stick to their long-term strategy.
“Set and forget”
The idea here is that an investor should establish a sound investment strategy, automate it, and then forget about it. Rather than tweaking and adjusting the strategy in response to the changing environment, an investor should stay the course, thereby minimizing the transaction costs associated with buying and selling and reducing the risk of emotional decision-making.12
The principle of avoiding unnecessary costs is sound. After all, every trade incurs costs—both hard transaction costs and more ill-defined opportunity costs—and therefore, to cover those costs, investors who trade more must pick more winners and generate higher returns than investors who trade infrequently.
However, it is nevertheless likely that portfolios will need to be adjusted over the long term—many investors, for example, reduce their equity exposures as they approach retirement.
Value investing is an active strategy in which investors intentionally take advantage of the lower prices obtainable during bear markets to purchase high-quality stocks.13 In other words, value investing is the practice of buying when the market or individual stocks are priced low.
Value investing demands a degree of skill and knowledge that few retail investors have. However, for those with the skill, value investing can generate market-beating returns.
10 Charles Schwab. What is Dollar Cost Averaging? February 2, 2017.
11 Forbes. How to Invest with Dollar Cost Averaging. February 10, 2022.
12 Morningstar. In Praise of the Dead. February 14, 2020.
13 Schroders. What is Value Investing? N.D.
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