Investing can be challenging- not only because financial markets fluctuate, but because human behavior can influence our financial decisions.
When markets fall sharply, it can feel as though holding more cash is the safest choice. When markets rise quickly, it can be tempting to invest more aggressively because it seems like the gains will continue.
These reactions are understandable. But they can also lead investors to make decisions based on emotion rather than their long-term financial plan.
Two behavioral tendencies that can influence investors are herd behavior and recency bias.
What Is Recency Bias in Investing?
Recency bias occurs when people place too much emphasis on recent events when making decisions about the future.
When markets have performed well, investors may begin to expect continued gains. When markets have declined, investors may expect additional losses.
The problem is that financial markets are inherently uncertain. Past performance does not guarantee future results, and even experienced investors cannot consistently predict when major market movements will occur.
This is one reason a well-designed investment strategy should be based on your goals, time horizon, risk tolerance, and financial circumstances rather than on predictions about what the market will do next.
The SEC's Investor.gov guidance emphasizes defining investment goals, developing an appropriate plan, understanding risk, and maintaining a long-term perspective.
How Herd Behavior Can Affect Investment Decisions
Humans naturally look to others when making decisions, particularly when uncertainty is high.
In financial markets, this can lead to herd behavior- buying investments because others are buying them or selling because others appear to be selling.
When markets are rising, investors may feel pressure to participate before they miss out.
When markets are falling, the opposite can happen. Fear can make investors want to sell investments to avoid further losses.
Neither reaction necessarily reflects the investor's actual financial needs.
A better approach is to ask:
- What is this money intended to accomplish?
- When will I need the money?
- How much investment risk can I reasonably accept?
- Do I have enough cash available for near-term expenses?
- Has anything about my financial circumstances actually changed?
These questions can help separate a genuine change in financial circumstances from an emotional response to market volatility.
Your Emergency Fund Can Help You Stay Invested
One of the most effective ways to reduce the pressure to sell investments during a market downturn is to maintain an appropriate emergency fund.
An emergency fund is designed to provide accessible money for unexpected expenses or a temporary loss of income. Investor.gov identifies savings accounts as an appropriate place to hold emergency funds and other short-term savings.
Your emergency fund is not intended to maximize investment returns.
Its purpose is to provide financial flexibility when something unexpected happens.
For example, an emergency fund could help you handle:
- A temporary loss of employment
- An unexpected home repair
- A major automobile repair
- A significant medical expense
- An urgent family expense
- Other necessary expenses that were not included in your regular budget
Having cash available for these situations can reduce the likelihood that you will need to sell long-term investments at an inconvenient time.
How Much Should You Keep in an Emergency Fund?
There is no universal emergency-fund amount that is appropriate for every household.
A common starting point is to maintain several months of essential expenses in accessible savings, but your appropriate amount depends on your circumstances.
Consider factors such as:
1. How stable is your income?
If your income is highly predictable and your employment is relatively stable, you may need a different cash reserve than someone working in an industry with frequent layoffs or variable compensation.
Business owners, commission-based employees, contractors, and individuals working in volatile industries may also want to consider a larger reserve.
2. How long might it take to replace your income?
Consider how difficult it would be to find another position with comparable compensation.
If finding a comparable job could take many months, having additional accessible savings may provide greater financial flexibility.
3. What are your essential monthly expenses?
Start by identifying expenses you would need to continue paying if your income temporarily stopped.
For example, suppose your essential expenses total $5,000 per month:
- 3 months: $15,000
- 6 months: $30,000
- 12 months: $60,000
These are illustrations- not recommendations. The appropriate amount depends on your household's financial circumstances.
Your Emergency Fund Is Not an Investment Portfolio
It can be frustrating to see money sitting in a savings account when investments may potentially earn higher long-term returns.
But comparing an emergency fund directly with a long-term investment portfolio misses the purpose of each.
Your investment portfolio is designed to help pursue long-term financial goals.
Your emergency savings are designed to provide liquidity and financial stability when you need it.
The appropriate cash reserve may therefore be influenced more by your spending needs, income stability, and financial risks than by what the stock market happens to be doing.
The objective isn't necessarily to maximize the return on every dollar you own. It is to give each dollar an appropriate job.
Should a HELOC Be Part of Your Emergency Fund?
Homeowners sometimes consider a home equity line of credit (HELOC) as a potential backup source of liquidity.
A HELOC can provide access to borrowing against home equity, but it should not automatically be treated as a substitute for cash savings.
There are important considerations, including:
- Interest rates can change.
- The lender may have the ability to freeze or reduce available credit under certain circumstances.
- Borrowing creates an obligation to repay the money.
- Your home secures the line of credit.
- Access to credit may not be available when you need it most.
For these reasons, a HELOC may be considered as one component of a broader liquidity strategy for some homeowners, but it is not the same as having cash readily available.
Discuss the advantages, risks, and costs with your financial professional and lender before relying on a HELOC as part of your emergency strategy.
Build an Investment Strategy Before the Market Gets Emotional
The best time to establish your investment strategy is generally before you are confronted with a major market decline or a rapidly rising market.
Your plan should account for:
- Your financial goals
- Your investment time horizon
- Your risk tolerance
- Your expected cash-flow needs
- Your emergency reserves
- Your retirement income needs
- Your overall financial circumstances
This can help you determine how much money should remain accessible for short-term needs and how much can be invested for longer-term objectives.
It can also give you a framework for evaluating market volatility without having to make a new decision every time the market moves.
Don't Let Market Volatility Dictate Your Financial Plan
Market declines are uncomfortable. Rapid market increases can create a different kind of pressure—the fear of missing out.
Both situations can encourage investors to abandon their long-term strategy.
Instead of trying to predict the next market move, focus on the things you can control:
- How much you save
- How much cash you maintain
- How much risk you take
- How your portfolio is diversified
- How much debt you carry
- How your investments align with your goals
- How you respond when markets become volatile
A financial plan can provide a framework for making these decisions before emotions take over.
How a Financial Advisor Can Help
Financial planning is about more than selecting investments.
A comprehensive plan can help you evaluate your cash reserves, investment strategy, retirement goals, taxes, insurance, income needs, and other financial priorities together.
A financial advisor can also provide an objective perspective when markets are volatile and help you evaluate whether a proposed change is driven by a genuine change in your circumstances or simply a reaction to recent market performance.
Build a Plan You Can Stick With
You don't need to predict the next market crash or the next market rally to become a successful long-term investor.
Instead, establish a financial strategy that recognizes that markets will fluctuate and that human emotions can influence investment decisions.
Maintaining an appropriate emergency reserve, investing according to your goals and time horizon, and having a written financial plan can help you make decisions based on your circumstances rather than the latest market headline.
At Dunncreek Advisors, we help individuals and families evaluate their financial circumstances and develop comprehensive financial plans designed around their goals and priorities.
If you have questions about your emergency fund, investment strategy, or retirement plan, contact me today- I'd be happy to start the conversation.
This article is provided for general educational purposes only and is not individualized investment, financial, legal, or tax advice. Investing involves risk, including the potential loss of principal. Past performance does not guarantee future results. Any discussion of financial strategies should be evaluated in light of an individual's specific circumstances. Dunncreek Advisors does not provide legal or tax advice.
Frequently Asked Questions
1. What is recency bias in investing?
Recency bias is the tendency to give too much weight to recent events when making decisions about the future. In investing, this can cause someone to become overly optimistic after strong market performance or overly pessimistic after a market decline. Recognizing this tendency can help investors make decisions based on their long-term financial plan rather than recent market movements.
2. How much money should I keep in an emergency fund?
There is no single amount that works for every household. Your emergency fund should reflect factors such as your essential monthly expenses, income stability, employment situation, dependents, debt, and access to other resources. Many households start by considering several months of essential expenses, then adjust the amount based on their individual circumstances.
3. Can an emergency fund help me avoid selling investments during a market downturn?
Yes. Having readily accessible savings for unexpected expenses or temporary income interruptions can reduce the need to sell long-term investments when markets are down. The appropriate amount of emergency savings depends on your circumstances and should be considered as part of your overall financial plan.