The S&P 500 is within striking distance of its all-time high. The TSX closed Tuesday at 34,291, supported by the same energy sector that rattled investors when Brent crude first broke $80 in early March. By most measures, markets have priced in the Iran war and moved on. A meaningful segment of retail investors has not.
Fund flow data from the Investment Company Institute shows that equity mutual fund and ETF redemptions spiked sharply in the two weeks following the February 28 U.S.-Israel strikes on Iran, with retail investors pulling billions from equity positions as the Strait of Hormuz closure sent oil prices from roughly $60 a barrel toward $110. The S&P 500 fell approximately 9% from its January 27 peak to its March 30 trough. Then it recovered. The investors who left during that window have, in many cases, not returned.
Why Vivid Events Override the Base Rate
This is not irrational behaviour, in the clinical sense. It is the availability heuristic operating exactly as described by Daniel Kahneman and Amos Tversky in their foundational 1973 paper in Cognitive Psychology. The heuristic holds that people estimate the probability of an event based on how easily examples come to mind. Events that are recent, emotionally intense, and widely covered feel more likely to recur than events that are statistically equally probable but less salient.
The Iran war meets every criterion for a maximum-availability event. Footage of missile strikes, maps of the Strait of Hormuz, oil price charts with near-vertical trajectories, daily news coverage of ceasefire collapses and naval skirmishes. Each news cycle refreshes the salience. The question an investor is unconsciously answering when they decide whether to return to the market is not "what does the historical base rate of geopolitical shock recoveries look like?" It is "how likely does another leg down feel?" And right now, for investors who experienced the February shock, another leg down feels very likely, because the vivid memories of the first one are still fresh.
The chart above shows the S&P 500's drawdown and recovery during the 2026 Iran war shock, alongside the VIX (the CBOE volatility index), which spiked to its highest levels since April 2025 during the initial sell-off. The divergence between where markets are today and where the VIX remains illustrates the gap between objective market pricing and the subjective sense of ongoing danger.
The S&P 500's full recovery to near-peak levels occurred while Iran war headlines remained consistently negative. The gap between the market's forward pricing and retail investor sentiment reflects the availability heuristic at scale.
The Availability Effect Fades Unevenly
Kahneman and Tversky's subsequent work on prospect theory, published in Econometrica in 1979, added a further dimension. Loss aversion, the tendency to weight potential losses roughly twice as heavily as equivalent gains, interacts with the availability heuristic in a way that is particularly damaging for investors who have already realized a loss. Having sold at the trough in late March, these investors are not just experiencing fear about future losses. They are experiencing the psychological pain of a realized loss, which makes the decision to re-enter the market feel like doubling down on a bet that already hurt them. The re-entry price is now higher than the exit price, which triggers additional loss aversion: the prospect of paying more than they received when they sold feels intolerable, even when the long-term case for being invested has not changed.
Richard Thaler's work on mental accounting, developed through the 1980s and 1990s, provides the accounting framework these investors are using. The portfolio is mentally segregated. The "Iran account" holds the realized loss. Re-entering the market at a higher price does not feel like adding to a long-term investment. It feels like paying a premium to get back into a position that already cost them money. The framing is wrong but the feeling is real, and the feeling is what drives behaviour.
What the Data Says About the Cost
Morgan Stanley's research on the long-term cost of market-timing behaviour provides the most directly relevant data point. Investors who remained fully invested from 1980 through February 2025 earned average annual returns of approximately 12%. Investors who sold during downturns and waited for two consecutive years of positive returns before re-entering earned approximately 10% annually over the same period. On a $500,000 portfolio over 20 years, that two-percentage-point gap compounds to a difference of several hundred thousand dollars. The Iran war shock is a fresh instance of the same behavioural error that has been studied in every major market dislocation since the 1987 crash.
The specific mechanism Vanguard senior economist Kevin Khang identified in his April 22 commentary is worth noting: the discomfort of a drawdown is a stress test of an investor's actual risk tolerance, not their stated risk tolerance. Investors who sold during the Iran shock revealed a gap between those two measures. The availability heuristic is now keeping them out of the market. The advisor who surfaces that gap explicitly is doing the work that the heuristic is preventing the investor from doing alone.