The past few years have been anything been ordinary, and as a result, we have been experiencing unsettling times in the financial markets and the economy in general. While many of the challenges we have faced recently have been unprecedented in our lifetimes, how many people have reacted to these conditions follows common mistakes inherent in human personalities. As a Wealth Advisor, I’ve come to expect these common investor pitfalls, and I have learned how to identify and counteract many of the potential consequences that could befall those who are not aware of their bias.
Traditional finance theory assumes that people are rational, unemotional, and always make logical decisions. In reality, we all know humans are not always rational, and their decisions are often influenced by various behavioral biases. Behavioral finance is an interdisciplinary field that integrates psychology and finance to study how people make financial decisions. It examines the cognitive and emotional biases that influence investor behavior and the resulting effects on financial markets.
Let’s take a look at some of the most common behavioral finance missteps that financial professionals face, in good and bad markets.
Perhaps the most common behavioral bias, and perhaps the one that comes most naturally to us, is recency bias. Recency bias is the tendency to give more weight to recent events or information than to historical data. In the context of investing, this bias may cause investors to make investment decisions based on short-term trends, rather than considering their long-term goals, leading to potentially poor investment decisions, and missed opportunities.
To best illustrate this, consider the S&P 500 over the past 33 years (January 1989 through November 2022). If your recency bias, as it pertains to the volatility in the stock markets, had you parking your investments on the sidelines waiting for everything to “cool down” instead of maintaining a planned investment strategy, you could do significant damage to your long-term goals. Research from Bloomberg and Goldman Sachs shows that missing the best 10 days in this time period, took the annual average portfolio return from 11% per year down to 8.5%, which was less than the 3.3% average inflation rate over that same period. That is 10 days out of 33 years! Furthermore, over the same period, missing the best 40 days took the average annual return to 4%, and missing the best 70 days resulted in a 0.6% annual return, on average. Based on this study, equities accumulated most of their gains over just a few trading days. This is why you may have heard your financial professional say that time IN the market is more beneficial than time-ING the market. We say it all the time because it’s true.
The second potential pitfall we try to help our clients avoid is known as herding bias. Herding bias is the tendency to follow the crowd and do what others are doing, rather than making independent investment decisions. Perhaps we could rename this the Bitcoin bias!
Herding bias may cause investors to buy securities that are popular (and often overpriced) rather than considering whether they are appropriate for their individual investment goals and risk tolerance. We inherently know the common investment adage, buy low and sell high, but that often is forgotten in the frenzy of a popular new investment. As Warren Buffett was famously quoted, “Be fearful when others are greedy and be greedy when others are fearful.” Unfortunately, the fear of missing out often has investors wanting to jump on a climbing train just as it crests the mountain.
Through periodic rebalancing, financial advisors try to take the emotion out of the peaks and valleys of the markets by selling from positions that have benefitted from recent market trends, even if the holdings are really popular and making all the headlines. Reallocating money to assets that are currently out of favor (basically, buying stock on sale rather than when they are demanding a premium) helps counteract the effects of herding bias.
The third common stumbling block that people sometimes have trouble identifying and avoiding is the gambler’s fallacy. The gambler’s fallacy is the belief that previous events affect the probability of future events, even when they are mutually exclusive. This pitfall can lead investors to believe that a security is more likely to increase in value because it has been increasing in value recently, even though there is no guarantee that it will continue to do so. From crypto to coin flips, there is a natural inclination to assume that when we are on a streak there must be some rationale to it. We know that when we flip a coin once we have a 50/50 chance of heads. But if we flip the same coin ten times and get heads every time, do you know what the odds are the next flip is heads? It is still 50/50. Coin flips, dice, roulette wheels, and financial markets don’t have memories. They are only influenced by the current pressures placed on them, and even though it may seem logical that streaks should continue, statistically there is no such thing as a “hot hand.” There are a lot of pretty buildings built in Las Vegas that bank on you not noticing when you are falling for the gambler’s fallacy.
Self-control bias is the tendency to prioritize short-term gratification over long-term benefits. In the context of investing, this can lead to investors making impulsive decisions or giving in to market trends, rather than sticking to a long-term investment strategy. When we create a financial plan, we plan an investment strategy for years and lifetimes, not the next few months. The most successful investors stick to those plans and adjust to major life changes accordingly. These investors aren’t betting their retirement on the talking heads on tv. News shows need viewers, and nothing draws eyeballs like the next pending calamity; however, what may be big news today (the next election, the next conflict, or even the next recession), rarely tips the scales historically when it comes to your retirement portfolio. The Great Recession of 2008 saw the markets drop 40% but most investors, who stayed invested, recovered their losses in 18 months¹. Those who didn’t or couldn’t stick to a diversified and disciplined investment plan may have never recovered.
Guiding You Forward
Behavioral finance offers valuable insights into the cognitive and emotional biases that influence investor behavior and decision-making. Investors who are aware of these biases, and their potential effects, can make better-informed decisions to develop with a well-informed investment strategy based on their own investment goals and risk tolerance. By incorporating a disciplined and objective approach to investing and a solid financial plan, investors can often avoid common behavioral finance mistakes and have a better shot at achieving long-term investment success.
At Pathfinder Wealth Consulting, we do more than build portfolios and monitor investments. We take an active approach to creating long-term strategies with our clients. While we do not know from where the “bumps in the road” will come along the way, we are certain they will come. We work hard to prepare our clients for inevitabilities, and we try to recognize the biases as they appear in an effort to keep our clients from allowing these biases to derail from their long-term path.
At Pathfinder, our firm was built on the idea of guiding individuals and families forward along their unique financial path; this means especially through the rough patches. If you have found yourself at a decision crossroad, we would be happy to construct a financial plan unique to your situation and goals that will help illuminate your options and help you make an informed decision. We want to help our clients counteract the biases that can hinder their plans for a more fruitful future. For more information, please give us a call at 910-793-0616. We are here to guide you forward.