Hype, panic and portfolio drift: back-to-school lessons for investors

As taken from the Globe and Mail....

Investors may be feeling seasick right about now. The boom of the Magnificent Seven tech stocks led to stock market highs in the early part of 2025. Then, U.S. President Donald Trump’s tariff plans led them to tumble, with the S&P 500 hitting a low of 4,900 in early April, down almost 20 per cent within a month.

Since then, the President has backed off his most extreme tariff threats, the artificial intelligence frenzy has continued, and the S&P 500 closed at another high of just over 6,500 on Aug. 28. Is that the end of the storm? Not quite. As we head into the fall, everyone is wondering what the last quarter of 2025 may hold in store.

Taken together, these events have triggered a cascade of emotional reactions: FOMO (the fear of missing out), FOLM (the fear of losing money) and FOD (the fear of deciding). This is to be expected – these are classic investor reactions to market uncertainty. By putting on a behavioural finance hat, however, all of this can be lumped into the “noise” bucket: events that are compelling and nerve-racking in the moment but largely irrelevant to long-term portfolio goals.

Indeed, the fall is a perfect time to revisit the key emotional traps investors are likely falling into and the steps they can take to course correct.

With today’s market, investors close to retirement face precarious times

First, loss aversion, the behavioural phenomenon that has us feeling the pain of losses twice as much as the pleasure from gains. Investors who gained in recent years from the tech and AI boom fear selling now and missing out on further gains.

Of course, the desire not to crystallize gains also comes from the very understandable desire not to realize gains on which taxes are due. But that rational motivation needs to be balanced with the awareness that too many investors ride gains for too long, much to their detriment. Many Canadian investors can painfully recollect their experiences with Nortel, Bre-X, RIM and Valeant.

Second, recency bias, the belief that recent market momentum will continue indefinitely. Market history is full of sudden reversals – both from bull-to-bear markets, as in 2007-2008, when the housing and raw materials boom gave way to the Great Recession, and from bear-to-bull markets, as in 2009 onwards, when the despair and depths of the Great Recession powered an impressive rally. The key lesson for investors is that trends continue until they don’t and it is impossible for most investors to time the reversal accurately.

Third, the endowment effect, which sees investors overvaluing what they own and refusing to change things up, even when diversification makes sense. This has led to investors holding onto positions in stocks or sectors long after the economic cycle has moved on.

Fourth, and especially a factor in today’s world of social media influencers, is the confirmation bias, which sees investors actively seeking out data that validates their positions and ignoring contradictory signals. Bubbles and hypes are largely driven by this phenomenon and affect retail and sophisticated investors alike. Witness the recent scandals with WeWork, FTX, Theranos and the like.

So, what’s an investor to do? Much like students are encouraged by their teachers to focus on the basics or go back to fundamentals in solving classroom problems, investors should consider doing the same.

In times when information overload creates “noise” that drowns out any actual “signals,” it is even more critical for investors to anchor themselves to fundamentals that have stood the test of time and market conditions.

Overconfidence in money decisions is created by making decisions, not gaining new knowledge

Here, the first fundamental is goals-based planning. Investors need to use long-term financial and non-financial objectives to shape their portfolio allocation and strategy. Of course, these objectives need to be grounded in the investor’s personal circumstances and realistic expectations rather than wishful thinking. This approach is critical for keeping emotional decision-making at bay, rather than giving in to FOMO, FOLM or FOD.

Second, diversification continues to be critical. When your grandmother warned you not to keep all your eggs in one basket, she knew what she was talking about. But investors need to remember that in our interconnected world, diversification means more than just “different stocks”; a properly diversified portfolio must include exposure to different asset classes (i.e., stocks, bonds, cash), different regions (Europe, Asia, etc.) and different industries and sectors (industrials, consumer, etc.).

Third, the rebalancing of portfolios is vitally important although often ignored by investors. Like a “controlled burn” in forest fire management, rebalancing reduces the risk of a full-blown disaster. For example, investors who applied a systematic goals-based planning approach might have arrived at an overall optimal portfolio mix of 60 per cent equities and 40 per cent bonds.

But in the recent runup of the stock market, the portfolio may look more like 80/20. While it’s tempting to let those gains ride, this is where danger lurks. Markets revert, and asset class gains return to their long-term historical average rates of growth, so strong asset classes will weaken and weak asset classes will strengthen over time. Rebalancing simply takes money from areas that have done well in the past to areas that have lagged and are poised for relative outperformance ahead.

Two other pieces of practical advice for investors can help them prepare for the uncertainty ahead. One, don’t try to time the market. No one has ever been able to do it well consistently. And evidence shows that missing just the 10 best days in the market over 20 years – 10 trading days out of 5,000 – can cut your returns in half.

Two, build slack into your portfolio. In other words, keep cash reserves or defensive positions. This liquidity provides investors room to breathe, think and act, rather than blindly react to noise.

Investors will do well to remember that market cycles of hype and panic are a feature, not a bug, of investing and are here to stay.

Benjamin Graham said it best: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”