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Financial Planning > Behavioral Finance

Avoid These Behavioral Traps When Markets Slump

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What You Need to Know

  • Economic models typically assume that humans are self-interested people making rational economic decisions, despite considerable evidence to the contrary.
  • Confirmation bias often leads investors to avoid or downplay arguments that contradict their investment positioning.
  • Advisors should think about how they'd invest were they starting a portfolio from scratch without a performance deficit to make up.

Global economic growth is likely to fall from peak levels in the coming months, threatened by rising prevalence of the Delta variant of COVID-19, inflation that may remain stubbornly high and an uncertain policy outlook for the U.S. and China.

With the economy facing an unpredictable transition, the “fog” of uncertainty may cause clients and advisors to fall into counterproductive behavioral patterns. Advisors should resist the attraction of behavioral traps and coach their clients to be aware of the destructive nature of many common impulses. 

Economic models typically assume that humans are self-interested people making rational economic decisions, but there is considerable evidence to the contrary. Social media amplifies the tendency of investors to make less rational decisions; Bitcoin volatility coinciding with tweets by Elon Musk and rapid swings in “meme” stocks such as AMC and GameStop are examples in which price moves appear disconnected from fundamentals. Social media and “gamification” of trading may also influence excessive trading or risk taking. Advisors should develop a plan to mitigate the most common behavioral traps

Confirmation bias is the tendency to seek evidence that supports one’s beliefs, and to interpret information in a way that supports a current position. Confirmation bias is ubiquitous in the political realm, with many news providers reporting stories in a manner that reinforces the beliefs of their core audience. Confirmation bias is also a problem for investors, many of whom avoid or downplay arguments that contradict their investment positioning.

Overcoming confirmation bias is conceptually straightforward but can be uncomfortable in application. Seeking contrary opinions is a logical starting point for advisors seeking to avoid confirmation bias. Some advisors have a systematic approach to identify flaws in their investment thinking, assigning a team member to provide the counterpoints to argue against a proposed investment decision.

The availability bias, or heuristic, is a mental shortcut that occurs when people make judgments about the likelihood of an event based on how easy it is to think of examples. Some events are easier to recall than others, not because they are more common but because they stand out in our minds. Events that draw more media attention — such as plane crashes, earthquakes, and terrorist events — are considered higher-probability events than statistics would indicate.

People ascribe a higher probability to information and events that are more recent, that were observed personally, and were more memorable. Memorable events tend to be magnified in importance and are likely to cause an emotional reaction.

Investors commonly use mental shortcuts or rules of thumb for guidance, relying too often on stories rather than analysis to make decisions. Headlines satisfy the human need for coherence and require less effort than applying statistical reasoning.

Statistical analysis is an important tool for avoiding the damage caused by the availability bias, as is examining the perspective provided by past events. Prior probabilities (“base rates”) may provide context into how frequently an event has happened in the past, the magnitude, and the duration. Base rates can also identify the potential size of an opportunity. Imposing a slower and more systematic decision-making approach can be a valuable tool in mitigating availability bias. 

Overconfidence is another common behavioral challenge. Nobel Prize-winning psychologist Daniel Kahneman’s research cited a study of entrepreneurs in which 81% of respondents put their personal odds of success at 70% or higher, in stark contrast to statistics that indicate that the odds of a small business surviving in the U.S. for five years are about 35%.

The illusion of control is a related bias, in which people overestimate their ability to influence external events. Startups are influenced as much by the actions of competitors and changes in the market as their own efforts. Overconfidence and the illusion of control can lead to a tendency for advisors to trade too much, or to underestimate the role of luck or timing in investment success.

Some advisors complete “premortems” before making an investment. Participants in the premortem are asked to imagine being one year in the future, and to explain why the investment failed. The concept of a premortem helps to overcome “groupthink” and often identifies threats that have been neglected in the investment analysis.

Whether making decisions as a group or individually, the premortem can raise the quality of investment decision-making and serve as a restraint on overconfidence. 

Loss aversion is a major challenge for advisors and their clients. The tendency of humans to feel more pain from economic losses than pleasure from equal gains contributes to the tendency of investors to sell winners too soon and hold on to losers for too long. Loss aversion is also the tendency of some to seek risk to avoid losses.

For advisors trailing their benchmarks, it may be tempting to take more risk or “double down” on existing risks to catch up after a period of underperformance. Before taking on more portfolio risk, advisors should think about how they would invest if given a “blank sheet of paper” — that is, starting a portfolio from scratch without any performance deficit to make up.

The behavioral bias of loss aversion is compounded by a common investment misconception that equates risk to volatility. For most investors, volatility is not the most important investment risk. Rather than volatility, the most significant risk is that of a permanent loss of capital. Most causes of permanent loss of capital are self-inflicted.

Failing to maintain enough liquidity to meet unexpected expenses increases the likelihood of having to sell assets at inopportune times. Being overly leveraged also raises the vulnerability of being a forced seller, the unfortunate fate of too many real estate investors in 2008 and 2009. Panic is another common trigger of permanent loss of capital and was a destructive impulse for many investors in the first stage of the COVID-19 pandemic. Understanding the distinction between volatility and permanent loss of capital is an important dimension of mitigating behavioral traps.

Awareness of behavioral biases can provide a road map for counteracting harmful behavior. Although mental shortcuts are helpful in day-to-day life, a slower and more methodical investment approach is likely to be a recipe for success for advisors and their clients.

 Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston. Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds. Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the board of trustees for the Green Century Funds.


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