Imagine that a decade ago, you planted a tree in your front yard. You’ve worked hard to nurture it over the years, but one night, a thunderstorm knocks two or three branches off the tree. You wouldn’t decide, “Well that’s it, time to dig it up and replant it elsewhere,” would you? Of course not — one thunderstorm shouldn’t undo years of work, and digging up the tree would likely stunt its growth potential.
Right now we are in a financial storm, and understanding the principles of behavioral finance can help ensure that you don’t undo, or “dig up,” the years of hard work that you’ve put into your financial life.
Behavioral Finance & Irrational Behavior
In 1973, psychologists Daniel Kahneman and Amos Tversky published “Judgement Under Uncertainty.” The paper examined why humans behave irrationally and concluded that not only could irrational behavior be explained, but that there were patterns to that behavior.1 Kahneman and Tversky’s work earned the pair a Nobel Prize in Economics and eventually became what we know as behavioral finance: the study of how human psychology and biases impact financial decision-making.
So what is defined as “irrational behavior”? Common examples include fear or greed-driven trading, trying to time the market, or consistently “buying high” and “selling low.”
Why Investors Act Irrationally
Understanding why we fall into these traps is the key to avoiding them. Here are some behavioral biases that all humans are predisposed to:
- The tendency to extrapolate recent events into the future indefinitely
Recency bias is the belief that if the market is hot today, it will continue to be so. Consider, for example, the internet/technology bubble at the turn of the century. Similarly, if the market is in free fall, it seems as though there is no bottom in sight — think back to March of this year. Of course, we all know better, yet the more extreme the rise or fall, the more people tend to jump on the bandwagon.
- The loathing of losses
Research shows that the emotional experience of losses are felt two to two-and-a-half times as strongly as gains. For example, the emotions surrounding the loss of $1,000 are much stronger than the emotions surrounding a $1,000 gain. This irrational aversion to market losses may lead investors to do whatever they can to avoid a loss, even if it does not make sense for their long-term financial well-being.
- The tendency to collect information that confirms our beliefs
We like to think that we are objective and that we carefully gather and evaluate all pertinent information before reaching a conclusion. But we don’t. Instead, we have the tendency to reach a preconceived conclusion and then hunt for facts to support the narrative. This is called confirmation bias, and it can cloud the decision-making process.
How to Make Prudent Investment Decisions
Exhibiting these biases does not make you a bad investor; it simply makes you human. Every investor — from seasoned professionals to beginners — struggles with these biases. However, by understanding these psychological tendencies, we can develop strategies to reduce or eliminate them. Over the years, we’ve found three tactics to be especially effective:
- Have a well-designed financial plan
We believe once you have built a well-designed financial plan and a portfolio aligned with your interests and goals, sticking to the plan is what matters. And while it feels good to “do something” or “take action” during a financial shock like COVID-19, it’s more often both ill-timed and ill-advised.
- Plan for, and ride out, the financial storms
Think back to the tree analogy. When you planted the tree in your yard, you knew that storms would come along from time to time. Right now, we are in the midst of an economic storm that arrives once every decade on average. We made it through the dot com bubble, the 2008 financial crisis, and we will make it through COVID-19. Through financial planning and portfolio design we can prepare for these storms, and that makes riding them out much easier.
- Don’t try to make sense of day-to-day market movements
This is especially difficult in today’s 24/7 news cycle. Every media outlet is trying to capture your attention, and that desire encourages them to lead with fear-provoking or overly-dramatized headlines. In times of crisis, information overload can be very real, and reducing the amount of information that you consume may actually help you make better long-term financial decisions.
Performance, Wellness, & Resilience
By making prudent investment decisions today, we can lay the foundation for long-term investment performance and wellness. And in these uncertain times, the best way to ensure we’re making prudent decisions is by practicing resilience.
We tend to define resilience as how well we respond in times of crisis, but it also means being prepared for whatever comes our way.2 Physical resilience requires maintaining a healthy lifestyle with diet and exercise. An important part of your emotional resilience is identifying and avoiding cognitive biases within your financial plan.
We hope that our focus on behavioral finance, wellness, and resilience can be a useful resource for you during these unprecedented times. Especially now, we are here to support you and your long-term financial goals.