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.