Investing may be financial in nature, but emotions can quickly become tied to the account balances that are reported on our statements. This is especially the case when that balance has been declining. Behavioral finance is a complicated emotional issue. There are several biases that may negatively influence the financial decisions investors make. Contrary to what our emotions may lead us to believe, acting on these feelings could cause irreparable damage to an investor’s portfolio. Our job as wealth managers is to help our clients identify these biases and refocus the attention on their financial plans.
This may result in some self-reflection, as you consider a few of the common biases to be on the lookout for…
Control Bias – the belief that you can influence outcomes.
What you may think: “The market is dropping! We need to increase the trading activity in my accounts!”
What it really means: You may be losing sight of what is and is not within your control.
How it can damage your portfolio: The idea that increased trading activity leads to improved investment performance is not always true. In fact, it often has an adverse effect.
What to do about it: First, remind yourself of what is and what is not within your control. You cannot control when things happen. However, you can control your response to them.
Second, ask your wealth manager what has been done already. The activity you are seeking may have already taken place. It is important to be forward thinking with your investments and take a proactive approach. If you are reacting to old news, you may already be too late.
Finally, think back to your financial plan. By planning for a range of outcomes – good, average, or bad capital market performance – you and your Atlas advisor should have a sound understanding of what risk short-term volatility may pose to long-term financial well-being.
Recency Bias – only looking at recent history.
What you may think: “Another day in the red. We will never recover from this!”
What it really means: You may be putting too much weight on current events, or data, and not enough weight on historical trends.
How it can damage your portfolio: The thought that current market trends, good or bad, will continue in perpetuity can be extremely dangerous to an investor’s portfolio. These investors tend to buy-in at the peak when the markets enter their euphoria stage. They then sell into a correction when their assets, and their emotions, reach depressed levels. Essentially, this leads to a worst-case scenario. A portfolio that only participates in market losses and does not benefit from any of the gains.
What to do about it: Stop trying to time the market. Focus on your personal goals. Work with your Atlas advisor in building a long term financial plan. This may help to regulate emotions through market highs and lows.
Remember, time in the market is greater than timing the market. When a decision to sell out is made, this results in a need to make a series of subsequent decisions on when to begin reinvesting.
Anchoring Bias – latching on to a single point of view and ignoring the changing conditions.
What you may think: “Inflation is high! Gold was good in the late 70’s. Invest 25% of my portfolio into gold!”
What it really means: You may be looking at your strategy through a narrow lens and might not be seeing the bigger picture.
How it can damage your portfolio: Anchoring can come in many forms and if these feelings motivate investment decisions, it often leads to creating risks that were not previously there. Anchoring may lead to an over-exposure in one company, industry, or asset class. On the other hand, it could also cause you to avoid a potentially fruitful investment category due to a false negative perception.
What to do about it: Before any decisions are made, be sure that you have done your due diligence. Recognize that we are often in unique times. The economic environment and capital market conditions are constantly changing. This requires us, as investors and wealth managers, to be diligent in our duty to stay current.
Discuss your opinions with your Atlas advisor. In doing so, remain open minded to their point of view and the guidance they are offering. As the many corrections we have experienced in the last century have shown us, diversity among your investments is one of the most important aspects in portfolio management.
Loss Aversion – avoiding selling at a loss, even in the face of apparent risk.
What you may think: “I am not making changes right now. Maybe when the market recovers.”
What it really means: You may be suffering from the fear of regret, hoping for a recovery that may never come, or failing to admit a poor investment choice and/or strategy. Loss aversion is often linked with status quo bias. This is comfort in familiarity and the fear of change.
How it can damage your portfolio: As any investment disclosure would read, “past performance is no guarantee of future results”. Even strong blue-chip companies are not immune to risk. Take General Electric (GE) for instance, once the backbone of America and perceived to be among the strongest of stocks. Investors suffering from loss aversion are still waiting for GE to recover to its all-time high from more than 22 years ago. In this case, these investors would be anchoring themselves to GE’s previous highs. This also brings in the opportunity cost of missing out on other investments that have performed well over the years.
What to do about it: Consider whether your current strategy is appropriate for your future. Ask yourself, “am I holding this security because I do not want to sell at a loss, or because it serves my financial plans?” If the former, it may be time to reconsider your position.
Discuss these feelings with your Atlas advisor. Every investment should be carefully evaluated not only as an isolated position, but also for its role within the overarching portfolio strategy.
Confirmation Bias – seeking information that only supports your point of view.
What you may think: “I know that I’m right!”
What it really means: You may be relying on information that supports your current thinking and ignoring the information that does not.
The damage that can be done: Limiting the content you consume to only what confirms your current feelings can cause you to miss warning signs. You can imagine how ignoring the flashing lights may be dangerous to a portfolio. One may say that it is like driving down a road that is under construction when there is a clearly labeled detour. The ride may end up being just a little bumpier, or the road could be out altogether. In either case, you are probably better off avoiding that uncertainty and taking the detour.
What to do about it: When it comes to doing your own research, take in a full view. Look at cases that both support and challenge your current thinking. With the abundance of information available, this may prove to be a tall task, especially for retail investors who do not have an investment research team in their corner.
When you recognize this bias in yourself, speak with your Atlas advisor. Your Atlas portfolio management team has done their due diligence on your current holdings. Each investment is held for a specific purpose to fill a defined role within the portfolio. In reviewing your monthly statements, it may not be so clear or as easily understood. However, your Atlas advisor can shed light on the rationale behind each choice and help you to understand how the pieces of your portfolio puzzle fit together.
Hindsight Bias – should have, could have, would have.
What you may think: “That investment has outperformed! Why did we not invest more there!?”
What it really means: You may be under the impression that prior events were more predictable than they were.
The damage that can be done: Looking in the rearview at gains left on the table or other investment categories that may have performed better can quickly become a danger. It may lead to chasing gains and always being a step or two behind. As markets move through their cycles, you may find yourself investing in a category that does not continue to be a strong performer and moving out of assets that the cycle begins to favor.
What to do about it: Maintain a well-diversified portfolio. It is impossible to consistently time the market with accuracy. You may get it right once if you are lucky, twice if you are very lucky. For the rest of us, a well thought out strategy, consisting of several asset classes with a low correlation to each other, may create a more stable investment experience.
As previously discussed, it is important to recognize the unique environment we are always in. We must stay present and forward looking in our analysis. Historical trends can be helpful within the framework of a long-term cycle. Unfortunately, hindsight bias typically stems from a perceived failure to capitalize on short-term performance.
Discuss these feelings with your Atlas advisor. They may be able take your focus off what could have been done better and put it on what should be done from here.
Through difficult markets and/or economic times, it is easy to become emotional about our money. These emotions can cause us to ignore rational behavior and spur the biases mentioned above, as well as many others that were not covered. In recognizing these instinctive feelings, we can learn to regulate them and avoid making short-sighted decisions.
In most cases, the core issue is the fear that the savings we have worked so hard to accrue and invest over the years will not be there to serve its intended purpose. The reality is that many investors do not understand how short-term price volatility may affect their ability to fund their financial and life goals. Fortunately, a financial plan may help you to gain that perspective.
When we are emotionally invested, it can be difficult to be objective about wealth. Help combat these biases by discussing them with your Atlas wealth management advisor. Then take a planning approach to your financial well-being. Think about your money’s place in your life and the lives of your loved ones (e.g., providing current or future cash flow, unique goal funding, building generational wealth, etc.). Then develop a financial plan to better understand your ability to fund these goals, create strategies to narrow your range of outcomes, and give yourself the peace of mind that you have a course of action no matter the noise of the outside world.
Happy New Year and best wishes for a prosperous 2023!