By: Reed C. Fraasa, CFP®, AIF®, RLP®
As 2024 comes to a close, many investors find themselves reflecting on the stock market's performance over the past two years, wondering if history will repeat itself in 2025. It's a natural question highlighting the interplay of emotions, biases, and decision-making—the core of behavioral finance.
The Allure of Patterns
Human beings are pattern seekers. We often look at past performance as a predictor of future results, a cognitive shortcut known as the recency bias. This bias leads us to overemphasize recent events when making decisions, which can be misleading in the context of the stock market.
For instance, if the market delivered substantial gains over the past two years, some investors might assume similar returns are likely in the near future. Others might brace for continued challenges if the market experiences significant volatility or underperformance. Both approaches oversimplify a complex system influenced by myriad factors—macroeconomic trends, geopolitical events, and shifts in investor sentiment, to name a few.
Conversely, the belief that "if we had two good years, we must be due for a crash" is a classic example of the gambler's fallacy—the mistaken notion that past events influence future probabilities in independent systems. In the context of the stock market, this belief can lead to overly pessimistic decisions that might derail long-term investment strategies.
The Gambler's Fallacy in Markets
Like the flip of a coin, the stock market is not bound by past outcomes. While market cycles exist—bull markets often give way to corrections or bear markets, and vice versa—no rule or natural law dictates that a crash must follow a period of strong performance. Historical data shows that markets can sustain positive momentum for several years, just as they can endure prolonged periods of underperformance.
For example, the 1990s saw an unprecedented stretch of gains during the dot-com boom. At the same time, the 2009–2021 bull market ran for over a decade, punctuated by volatility but never a full crash until the COVID-19 pandemic.
Emotional Roots of the Crash Expectation
The expectation of an impending crash after strong performance is often driven by availability bias—the tendency to predict the future based on vivid, recent memories. Investors might recall the painful corrections that followed periods of euphoria, such as the market declines after the dot-com bubble or the 2008 financial crisis, and assume that a similar event is imminent. This outlook can be reinforced by media narratives that amplify fear, often framing gains as "too good to last."
However, this view oversimplifies market behavior. Market downturns are typically triggered by specific economic or geopolitical catalysts, not the mere passage of time or the sequence of prior years' returns.
The Emotional Rollercoaster
Behavioral finance also teaches us that emotions—especially fear and greed—play a significant role in how we react to market trends. After a period of strong market performance, greed can lead to overconfidence. Investors may believe they can accurately predict the next big winner or assume excessive risk, ignoring their long-term financial plan.
On the other hand, if recent performance has been negative or uncertain, fear can drive loss aversion, where the pain of potential losses outweighs the allure of future gains. This emotional response may push investors to exit the market prematurely, potentially missing out on future recoveries.
The Reality of Market Cycles
It's important to remember that the stock market operates in cycles, and no two years are ever identical. While the past two years may provide valuable context, they cannot reliably forecast what's ahead. History shows that markets are unpredictable, and even professional economists and fund managers struggle to time the market accurately.
Instead of predicting short-term performance, it's wiser to focus on the factors we can control: asset allocation, diversification, and sticking to a well-thought-out investment strategy. Behavioral finance emphasizes the importance of discipline and objectivity in navigating market uncertainty.
Preparing for 2025
As you consider your financial goals for the year ahead, ask yourself:
Are you making decisions based on logic or emotion?
Have you revisited your risk tolerance and time horizon?
Are you staying diversified and focused on long-term objectives?
The best strategy is often the simplest: stay the course. In fact, in 8 of the past 10 calendar years, the S&P 500 Index of the 500 largest companies in the US has experienced positive returns, and only two were negative. That follows a much longer-term pattern: roughly 75% of the time, the US stock market has been positive and about 25% negative. Avoid chasing recent trends or making reactive decisions based on fear. Remember that markets are inherently volatile, and short-term fluctuations should not derail your long-term plan.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.