At one time or another, most of us have likely succumbed to a common, yet financially fatal, bias that engages our emotions and causes us to act on our fears.
For example, have you ever sold a stock investment (mutual fund, ETF, etc.) after a market decline, only to realize that it was near a bottom and rebounded soon thereafter? If we are honest with ourselves, we would likely answer in the affirmative. Perhaps the better question is how many times have we done this? If we, as advisors, are susceptible, consider how our clients might feel when the market is in the midst of a correction.
In this post, we will examine how biases can thwart, even the best-laid plans.
A few decades ago, I had an epiphany when I noticed how an investor’s risk tolerance changed based on market conditions. In short, as stocks rose, they were willing to assume greater risk. When stocks were declining, they were more risk averse. This is only natural, given our proclivity to become greedy when financial markets are doing well and fearful when they are not.
Another observation involves the investor who invests in a security which declines after it was purchased. Here is an example to illustrate how human behavior can affect the latter issue.
Investor Bob purchases Security A at $20 per share. Shortly thereafter, the price falls to $15. Bob has lost 25% of the value of his original investment. Bob may decide to hold the security until it gets back to even before selling it. Why? Selling at a loss is tantamount to admitting he made a poor decision.
Moreover, he still believes his decision to buy was sound (actually, he may be in shock). However, when the price rises back to his initial price of $20, he is likely to hold it because the increase supports his original decision to purchase it. No one wants to be wrong. So Bob holds the security, it hit $20 again, and then rises to $25. At this point, Bob is feeling really good about his decision and will likely continue to hold it. His decision has been validated. In fact, Bob may be inclined to invest more since it has rewarded him so well. He is probably wishing he had done so in the beginning.
Finally, after a while, the market corrects, Bob’s investment falls back to $15 per share, and he has had enough. He wants out!
This all-too-familiar scenario is one of the reasons retail investors often underperform the broader market. Fear and greed, two of the strongest emotions, help explain why investors buy high and sell low, rather than the reverse.
We also see this during a financial bubble. An extended rise is often followed by extensive media coverage, and the retail investor simply cannot resist the temptation. He has to participate in the incredible returns. This is why a large amount of money is invested near a top, just before a correction.
As advisors, it would benefit us to learn all we can about human behavior for two reasons. First, we need to be aware of our own biases and avoid unfounded, emotional decisions. We must become a contrarian (although if everyone did this, the landscape would change considerably). Next, we must become properly equipped so we can help our clients avoid acting on emotion.
Perhaps over the next few weeks we will discuss this in more detail. If the correction continues, this is much more likely.
Until next time, thanks for reading and have a great week!
For more on behavioral finance, see fellow ThinkAdviosr blogger Stephen Wendel’s latest articles: