The Science of Successful Investing: Understanding Biases for Better Portfolio Decisions
When it comes to managing money, nobody’s perfect. Your relationship with money is molded by the events happening around you — how your parents handled money, financial trauma you may have been exposed to, and major financial events, among others. Most of this molding occurs unconsciously, especially during your early years.
You develop certain biases which can impact your ability to objectively and rationally manage your own money. We don’t often escape our biases. What you can do is be bias-aware. Behavioral biases are a big reason why working with a financial advisor is so helpful. A great advisor will be bias-aware while providing guidance and recommendations so that you get actionable advice that both feels good and is likely to work well.
Understanding Your Behavioral Biases
Some of the most common and impactful biases to be aware of (especially during periods of market volatility) include:
- Loss aversion bias
- Confirmation bias
- Recency bias
- Herd mentality bias
Let’s take a brief look at each one and discuss what you can do to manage them.
1. Loss Aversion Bias
If you feel more emotionally charged at the thought of losing money than gaining money, you are experiencing loss aversion. Well, congratulations, you are in the majority! Losing money is so painful for many of us that we’re inclined to abandon ship during a market downturn (typically, towards the bottom of the cycle) — rather than ride out the storm and allow your money time to recover and grow again.
We see loss aversion bias in action all the time, virtually every time the market cycle circles back into a downtrend. Investors panic, sell off stocks, and lock in (sometimes significant) losses — even if historical data trends tell us that staying invested is the better move. Current financial doomerism (read more here) is in many ways being driven by loss aversion resulting from the Great Recession, which ended over 14 years ago.
The key here? Never Interrupt compounding. This might be the single most important thing you can do to create wealth, in combination with systematically saving every time you get paid.
2. Confirmation Bias
As humans, we naturally seek out confirmation of our beliefs, thoughts, and values. It’s why people tend to watch or read news sources that politically lean in the same direction, for example. Along with trying to obtain confirmation of our beliefs, we tend to disregard evidence, opinions, or even data that contradicts them.
When the markets take a turn for the worse, confirmation bias can be especially harmful to investors. Managing your confirmation bias means you must be able to set your beliefs aside and assess the situation objectively.
Rather than rely on one news source to provide information, gather information from various credible sources and people (including your advisor). It’s natural to want to drown out news opposite to what you believe, but having a broad set of facts, and differing opinions are critical to making informed, forward-focused decisions.
The key here: Constantly seek disconfirming evidence.
3. Recency Bias
Recency bias pushes us to put more emphasis and importance on events or experiences that have happened recently (as opposed to events that happened further in the past).
Post 2008, even after a 68%(!!!) increase in the S and P 500 during 2009, many investors stayed out of the equity markets and missed multi-year, historic gains. The largest inflows into the equity markets were precisely in advance of the Great Recession (during the summer of 2007). The recency of the pre-Great Recession bull market had people piling into stocks at precisely the wrong time. During the spring of 2009, we saw historic flows into bond markets, also at precisely the wrong time.
We see that occurring now, as a great bond push is occurring. Yes, we have what I would consider reasonable bond yields for the first time in ten or so years, and if you are an income investor, moving more money to bonds is smart. At the same time, as of this date, the S&P is up 21% for the year, and if you are overweight bonds right now, you are missing out on a tremendous equity investing year.
The keys: Select a diversified strategy consistent with your time horizon and risk tolerance. Stick with it. Routinely, automatically save into that strategy.
4. Herd Mentality Bias
This is one you’ve likely heard before. People are inclined to follow what others are doing rather than make individual decisions that go against the grain. Anytime you see headlines about panic selling, that’s herd mentality at play.
Herd mentality is one of the drivers of market timing attempts. Substantial data shows that the great majority of investors fail miserably at market timing and, in fact, time completely wrong by entering markets at the top and exiting at the bottom.
Since 1925, any 20-year rolling period invested in the S&P 500 has had positive returns. The market rewards those who are patient and disciplined.
The key here: Stick with your strategy, especially when it feels like your strategy is failing.
Remember to Maintain a Long-Term Perspective
Your investment strategy should be built to anticipate market volatility. Despite investor reactions, volatility is a normal part of the market cycle. How to manage volatility? Be positioned to ignore it. Maintain an income reserve sufficient to carry you through down markets.
While watching your portfolio trend downward is never fun, it’s important to maintain a long-term perspective. If you “zoom out” and look at the history of the stock market, you’ll see that despite wars, recessions, crashes, crises, political upheaval, and everything else that’s happened in the last 200 years, the market has always trended upward.
Past performance doesn’t indicate or predict future performance. It is, however, a good reminder that what’s happening right now, or even in the past few years, is highly likely to be a blip when viewed in the timeline of your portfolio. There is research supporting strategies being “right” over 20 years, even though they were “wrong” for 10 or so years.
If you’re feeling stressed or are tempted to make changes to your plan based on what’s happening in the markets, reach out to your financial advisor. They can walk you through your financial plan and investment strategy, reminding you that safeguards are already in place to protect your desired future.
Need help reviewing your portfolio and navigating market movements? We’re here to help. Reach out today to connect with our team.