Research suggests that the average adult makes about 35,000 decisions each day. From the moment you wake up, your brain is faced with an onslaught of information. It’s a truly remarkable feat, and a person could easily become overwhelmed with the number of choices that confront us each day. To avoid a state of “analysis paralysis” our brains rely on mental shortcuts (heuristics) to help us simplify a situation and expedite the decision-making process without getting bogged down with details. Heuristics can be helpful, saving us time and mental effort. However, these cognitive shortcuts can also become colored by bias, distorting our interpretations of the world, and creating the potential for decision-making error.
For a typical investor, navigating the obstacle-course of information when choosing to buy or sell an investment can be potentially overwhelming, triggering shortcuts and biases that lead to irrational decisions and harmful financial errors. One of the most common examples of this, known as loss aversion bias, is acting to avoid losses more than to achieve gains. Loss aversion bias can prove most harmful in times of market volatility, driving investors to sell positions during a market low in hopes of preserving capital; however, this comes at the risk of missing out on the potential recovery. For example, 2018 was a turbulent year for markets with S&P 500 pullbacks of -10.32% in Q1 and -19.8% in Q4. DALBAR, Inc., which publishes one of the nation’s leading annual studies on investor behavior, found that the average investor underperformed the S&P 500 by -5.04% in 2018, illustrating the danger of being out of the market during a recovery period.
A second prevalent example, recency bias is the tendency to over-emphasize your most recent experiences when faced with a decision. In other words, recency bias is acting under the assumption that whatever is happening today will also happen tomorrow. This can cause investors to stray from their long-term investment plan by focusing too much on recent, short-term trends. In a bull market, this could mean taking on too much risk or overweighting an out-performing asset class. Conversely, in a bear market, recency bias can lead investors to sell out of the markets with the belief that the current downturn will extend into the future. Emotion-based investing is not a viable investment strategy, and its long-term effects often prove disastrous for a portfolio. The point of maximum financial opportunity in the markets often co-exists with the point of feeling most pressured to sell out of the markets, but we become blind to opportunity if we allow our emotions to govern our decisions. I imagine Ernest Hemingway, who eloquently defined courage as “grace under pressure,” might agree had he been a financial advisor. Acting on emotions is hardly graceful, often hysterical, and rarely profitable. Rather than fighting volatile markets with volatile decision-making, we should strive to respond with logic, discipline, and composure.
An objective financial plan is a valuable tool for investors to utilize to avoid these biases and maximize the chances of making rational investment decisions. When markets become volatile and headlines stir up emotions, your financial plan will provide an unwavering baseline for logical decisions rooted in your long-term goals, rather than short-term emotions. At Pathfinder, we build individual, unbiased financial plans for our clients, testing each plan against a variety of different market scenarios, including recessions and market downturns. We want to make sure our clients can ride through these periods of volatility without having to make untimely shifts based on emotion. To learn more about our process, and how a financial plan can help investors navigate market turmoil, give us a call at 910-793-0616 today. We are here to guide you forward.