Natural disasters, the European debt crisis and social and political upheaval in the Middle East have created recent market volatility and contributed to an ongoing sense of uncertainty.

With the credit crisis and ensuing market correction of 2008 still fresh in the minds of investors, the focus of many has been on capital preservation. The derivatives market is indicative of this prevailing mindset, showing that investors are currently spending 12 times more money to protect against a downturn in stocks than to capture the upside from a potential rally.

This behavior among investors is not surprising. Studies show that people tend to strongly prefer avoiding losses versus acquiring gains. Odds are often ignored and rational decision-making is abandoned as a result of people's aversion to loss. Unfortunately, this behavior can stifle investment goals, which generally require a long-term commitment. Saving to send a child to college can take 20 years. Building a nest egg for retirement can span the length of a career, lasting 30, 40 or even 50 years. Yet many investors with these goals base their investment decisions on recent history.

Risk should be calibrated to meet investment objectives. Over the long term, insufficient exposure to risk can be just as detrimental to investment performance as excessive risk. In the current market environment, an emphasis on capital preservation could leave college savings and retirement nest eggs underfunded. Very simply, investors cannot avoid taking risk and achieve their longer-term investment goals. An analysis of investor behavior, however, suggests that they ratchet up risk and lower risk at inopportune times.

Consider fund flows. More money starts to flow into stocks as the S&P 500 Index increases. Conversely, investors pull money out of stocks as the S&P 500 drops. In both cases, they are assuming that the most recent trajectory of stock prices will continue.

Based on stock returns from Jan. 1, 1950 through Oct. 31, 2011, this behavior is counterintuitive. During this 61-year period, risky assets provided less downside risk at longer investment horizons. For example, the worst one-year return for U.S. small-cap stocks was -45.9%. Expand the investment horizon and the downside risk for investors is sharply reduced. The worst 10-year rolling return for U.S. small-cap stocks was 3.2%. Held for 20 years, the worst return an investor would have experienced is 8.1%. Despite this evidence, investors still buy and sell stocks based on short-term fluctuations in stock prices.

This behavior is referred to as the "recency effect" in behavioral finance, a field of study that emphasizes the importance of human psychology in financial markets.

In addition to the recency effect and loss aversion, behavioral finance examines how herd behavior, overconfidence and representativeness impact investment decisions.

Herd behavior describes how individuals in a group can act together without planned direction. The term pertains to the behavior of animals in herds and to human conduct during activities such as stock market bubbles and crashes, sporting events and even everyday decision-making. Stock market trends often begin and end with periods of frenzied buying (bubbles) or selling (crashes). Many observers cite these episodes as clear examples of herding behavior that is irrational and driven by emotion-greed in the bubbles, fear in the crashes. Individual investors join the crowd of others in a rush to get in or out of the market.

Foibles of Human Nature

Meanwhile, overconfidence, a behavior regularly exhibited by individuals in which they overestimate their knowledge, underestimate risks and exaggerate their ability to control events, leads investors to try to time the market, often causing them to sell winners too early and hold on to losers too long. Representativeness describes how people tend to judge the probability or frequency of a hypothesis by considering how much the hypothesis resembles available data.

Many poor investment choices are a result of human nature. Behavioral finance suggests that humans are wired to consistently make some decisions that are not in their best interest. Opportunistically rebalancing a diversified portfolio over a long-term investment horizon can guard against this and help investors meet their investment objectives.

Investors underexposed to risk in relation to their long-term investment goals may want to consider allocating more assets to equity strategies. The stock market's current price-to-earnings ratio is below its historical average, which has generally been a good purchasing opportunity for long-term investors. A study of the S&P 500 Index's from 1945 through 2011 indicates that buying stocks when the market's P/E ratio was below average resulted in an annualized return of 15.9% for the next three-years. This compares to 6.8% for investors who bought when the P/E ratio was above its historical average.

Per behavioral finance some investors may ignore this data, concentrate on market uncertainty and maintain a focus on capital preservation. Others may realize that their portfolios are not properly balanced to meet their long-term investment goals and take advantage of an opportune time to buy stocks.

Christopher Blum is a managing director and chief investment officer of the U.S. Behavioral Finance Group at J.P. Morgan Asset Management.

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