by Connor Darrell CFA, Assistant Vice President – Head of Investment
Last week brought another series of large swings in equity markets as investors had to balance the still uncertain (though expectedly profound) impacts of government quarantining efforts relating to COVID-19 with historically strong economic policy responses. Markets managed to push meaningfully off of their lows, largely buoyed by optimism surrounding economic policy support. On Monday, the Federal Reserve announced that it would uncap the amount of capital it could pump into financial markets and established other means of providing liquidity to the system. This aggressive action was followed just days later with the passage of a $2.2 trillion fiscal response (known as the CARES Act) aimed at providing aid to troubled workers and businesses. Also hidden in the week’s news flow was a massive increase in claims for unemployment benefits, which skyrocketed to 3.3 million, smashing the previous record of 695,000. Additional data revealed that euro zone and Japanese manufacturing was in the midst of a sharp contraction. We expect the economic data to continue to worsen before getting better but remind investors that much of the negative data likely to come is already expected by markets, which are forward-looking by nature.
Behavioral Finance: A Primer
Much of our previous communication has been focused on providing our interpretation of the data related to the pandemic, as well as frequent reminders of the importance of discipline. But for many investors who are facing an unprecedented amount of volatility in markets, remaining disciplined is much easier said than done. As human beings, our brains are wired to address risks and evaluate decisions in certain ways, and in many instances, the mechanics of our cognitive functions can lead us to make investment decisions that may prove to be contrary to our best financial interests.
Interestingly, there is an entire field of finance that is devoted to studying the psychology of investing. Advancements in our understanding of the human decision-making process have provided practitioners of “Behavioral Finance” with lots to offer in terms of understanding the behavior of investors. In our view, one of the most important benefits of understanding behavioral finance is that we can use our understanding of our own psychology to help improve our investment decision making. Below, we provide a summary of some of the most significant psychological pitfalls and how they may negatively impact us over the long-term:
1. Loss Aversion
All investors hate losing money, but the concept of loss aversion goes beyond this simple notion and suggests that human beings’ aversion to paper losses can greatly impact investment decisions. Specifically, study after study has shown that the “pain” associated with losing money on an investment is more powerful than the “pleasure” derived from earning it. In the midst of a volatile market, this can cause us to feel the urge to take action in an effort to protect ourselves from realizing further losses, even if such action would not be in concert with our long-term investment objectives. In order to combat this desire, it is essential for us to focus on our goals and objectives in an effort to focus on the things we have direct control of over time. This might include making temporary adjustments to our savings and consumption rates or taking advantage of cost-saving opportunities such as lower interest rates, rather than making drastic adjustments to our portfolios.
2. Confirmation Bias
Another flaw in the way we digest information is confirmation bias. Confirmation bias occurs when we inadvertently place higher emphasis on data or information that supports what we already believe, rather than taking it into consideration at face value. For example, if we believe strongly in the resiliency of the U.S. economy, we may overemphasize positive information about U.S. stocks and discount whatever negative views we may encounter that do not support this belief. For many of us, this bias may lead to us rushing to sell positions that have underperformed on a relative basis and flock to those that have performed better. Giving in to these types of biases can cause us to sacrifice proper diversification in our portfolios at the precise time that diversification takes on heightened importance.
Herding is the behavior that leads to our desire to “follow the crowd.” This is often driven by fear of regret or of “missing out” (also known as FOMO). Throughout history, there are a plethora of examples of points in time where market sentiment reached levels that were far too extreme (this includes periods that fall in both bull and bear markets). In these instances, those who were able to refrain from following the popular decision (whether that be to buy more when stocks were expensive, or to sell when markets were in peril) have often come out ahead. Given the volatility we are experiencing now, it is important for us to take a step back and develop our own conclusions rather than simply following the trend.
4. Illusion of Control
Illusion of control bias is a bias in which people tend to believe that they can control or influence outcomes when, in fact, they cannot. One example of this bias in a practical study occurred when a social experiment conducted in the 1980’s found that people permitted to select their own numbers in a hypothetical lottery game were willing to pay a higher price per ticket than subjects gambling on randomly assigned numbers. The belief that we have more control than we really do on the outcome of our investment returns can lead us to take inappropriate action within our portfolios. To combat this, it is important to think of investing as a probabilistic activity, and that the probability of different outcomes is beyond our control. During periods of market stress, it can be easy to lose sight of the fact that long-term returns are driven largely by circumstances beyond our control, and that the probability of experiencing positive returns increases with an investor’s time horizon.
Representativeness is a type of selective memory that causes us to place too much weight on recent evidence rather than taking a more holistic approach to decision making. This can cause investors to focus too much on short-term performance without considering the evidence that may be found in the more distant past. With markets having fallen so quickly from their highs, there are likely to be many high-quality stocks out there which still have very promising long-term prospects but may have fallen considerably off of their previous prices. If we become too concentrated on the recent past, or even on the fact that these businesses may operate in industries that could be particularly troubled in the current environment (i.e., energy or consumer discretionary), we may be more likely to lose sight of the business’ strengths. All of the above biases are particularly important to consider in the current investing climate, because they can lead us to make suboptimal decisions during a time of stress. Behavioral economists have found that we can help to reduce the negative impacts that our cognitive biases may have on our decision-making process just by simply acknowledging that they exist. This can help us to remain more objective and less emotional when considering what (if anything) should be done to adjust our portfolios in this time of uncertainty.