The market has not been kind for the past nine months. Investor pessimism is high; an individual investor survey conducted by the American Associate of Individual Investor (AAII) reports that we are at the highest number of bearish investors since 2009. As of April 1st, this year, 59.4% of investors claimed to be bearish.
Investor pessimism at these lows is usually an indicator that we are almost through the worst. On the other side of this pessimism will be higher expected returns. When? I cannot be sure, but history tells us it will happen.
However, during times like this, humans disregard history and rationale and are more apt to let cognitive biases get the best of them. Cognitive biases are unconscious errors in thinking that arise from problems related to memory, retention, and other mental mistakes. It’s the brain’s way of simplifying the complex world we live in.
Investors’ cognitive biases show up in both good and bad markets, affecting our judgment and daily decisions. Sometimes their impact can be harmful, other times not. The key takeaway is that regardless of the impact, they prevent us from making rational and objective decisions.
Financial advisors have been offering the same counsel for years and yet every time a new bear market, recession, downturn, etc. occurs, counseling our clients starts from ground zero. The sage wisdom preached in the last market cycle has been forgotten, panic strikes, and poor decisions are made. Why? In part, due to biases. If we are aware of our biases, we can train our minds to adopt a new pattern of thinking and mitigate their effect of them.
Confirmation bias —seeking or emphasizing information that confirms what we think is true or validates our hypothesis.
This shows up in investing when individuals attempt to time the market, take on a “unique” investment opportunity, or predict the market in the short term. We seek information that validates our viewpoint and disregard opposing views. An example I commonly see is when individuals make investment decisions based on the media channel they watch.
Confirmation bias can lead to overconfidence in our thinking and disillusionment to risk. We are then blindsided by outcomes that counter what we believed to be true.
To reduce the impact of confirmation bias, avoid echo chambers and seek information that challenges your view and disconfirms your hypothesis. The more information we seek as to why we would be wrong, as opposed to right, the more logical we will be when making critical decisions. Ask yourself, is there data or information I am missing to make this decision? For example, investors pulling out of the market in the short term because of political turmoil should evaluate the fundamentals of companies and the economy. And avoid opinion pieces.
Anchoring —relying too heavily on initially offered pieces of information regardless of relevancy to the current situation.
Investors often anchor on an original purchase price or principal investment, preventing them from selling a position (or causing them to sell too soon). Investors also look at past performance as a prediction for future performance, making investment decisions heavily weighted on irrelevant information.
Anchoring clouds our assessment of what is an accurate value or decision for our situation. It can cause an investor to make a rash decision based on flawed information resulting in capital risk. I am witnessing this more today as clients remind me of the value of their portfolio at the beginning of the year. We anchor on the unrealized gain and pinpoint the dollar value lost (also unrealized). In the short term the loss looks steep; however, if you expand your data and look at forward earnings potential the view isn’t so gloomy.
The cause of anchoring is a result of the brain’s need to create mental shortcuts. To combat anchoring, increase your knowledge through research, use deductive reasoning, and consult with experts.
Recency bias — making decisions with a higher emphasis on the most recent events.
Investors tend to focus on the performance of assets in the recent term without benchmarking the return for comparison. We find assets with significant appreciation attractive and buy them at their peaks. A great example of this is the past few years of tech stock fever. Companies with no earnings were significantly overvalued and investors were willing to pay the price.
What is the impact? Investors forget about the cyclical nature of market or asset returns and make poor decisions such as selling at lows or buying at highs. Investors use current trends with a small sample size as their prediction metric. The overall impact is weighing too much of their decisions on performance as opposed to fundamentals, resulting in a loss of principle.
To avoid recency bias, seek an accurate picture of your financial situation (assets, liabilities, goals) and include diverse types of data in your analysis when evaluating investment decisions.
Loss aversion —a bias towards avoiding loss over seeking gains. The real or potential loss we experience is felt more severely than equivalent gains.
Loss aversion causes us to avoid small risks, even if they are worth it. You see this with early profit booking, holding onto losers, and sell-offs. Early profit booking occurs when a stock rises (even slightly) and the person is quick to sell and book the profit. The upside potential of the stock could be significantly larger, however, the fear of losing outweighs the opportunity of holding the position.
Loss aversion can also cause investors to do the opposite of what they should be doing: holding onto a position when they should sell the position. People continue to hold falling stocks because they believe it will go back up, even if the fundamentals of the company show an unpromising future. Lastly, this bias causes people to panic and attempt to cut their losses as the market drops sharply.
Loss aversion can cost us money; investors behave irrationally and make poor decisions resulting in greater losses. Remember, it’s only a loss once you sell, and it’s only a gain once realized.
To avoid this, step back, look at the big picture, and do not let emotions get the best of you. Create an investment strategy with your financial planner and stick to it.
We will always be battling our biases. However, merely knowing they exist will help us make better decisions in the future.
As a financial planner, I try to remind clients of the biases at play and, whenever we meet, revisit their financial plans, goals, and commitments with them. I stress the importance of making financial decisions based on technicals and fundamentals, not emotions. Sometimes the right thing to do is not the easiest thing to do, especially when it requires challenging our viewpoint, ignoring our emotions, and trusting others.
John Bogel said it well, “Time is your friend; impulse is your enemy.”
~ Rachel Bubb
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