Investors' Worst Enemy in 2021 Could Be Their Own Brains
Hindsight bias, recency bias and sunk cost fallacy are just three of several cognitive biases that investors need to overcome to achieve their financial objectives this year. To beat these biases, take your emotions out of the mix.
By most measures, 2019 was a very strong year for investors. Whether you invested in domestic or international companies, large or small capitalization stocks, or in most areas of the bond market, the past year’s market performance has been attractive across the board. While such a strong year is cause for exuberance among investors, it’s also important to understand that these experiences can have a serious impact on one’s future decisions in the form of cognitive biases.
Cognitive biases and the field of behavioral economics was popularized by psychologist Amos Tversky and Nobel Prize winning economist Daniel Nobel Memorial Prize-winning economist Daniel Kahneman. The field explores the effects of psychological, cognitive, emotional, cultural and social factors on individuals’ decisions. In particular, cognitive biases refers to how the framing of information can influence one’s judgment and decision-making. This can cause investors to make irrational choices by selectively remembering or forgetting particular information.
After such a wonderful year in the markets, investors may be tempted to let their emotions and biases play into their investment decision-making process. Therefore, it’s worth reviewing some of the more common biases, as well as methods investors can use to overcome them. Doing so will help prevent potentially costly missteps in 2020.
Prevalent Cognitive Biases
Hindsight Bias: Hindsight bias is when individuals overestimate, in retrospect, their ability to have predicted an outcome that they would have been unable to predict before it actually took place. This bias is particularly prevalent in market history after a major financial collapse. For example, after the dot-com bubble, market commentators would point to what had seemed like an inconsequential set of events as strong indicators of the troubled market. Naturally, if the indicators of such a disaster were so obvious then the large market drop would have been averted.
At the end of 2019, investors may look at the strong market performance as something that was expected due to favorable conditions, such as rock bottom interest rates, lower corporate taxes, and consistently strong unemployment numbers. In reality, after an extremely scary finish to 2018, most investors would not have predicted a roughly 30% return for the S&P 500. It only seems obvious after the fact.
Hindsight bias can lead an individual to be overconfident in their own ability to pick winners and losers in the market. Investors should be forewarned that market timing, stock speculation and general predictions of where prices are headed in the short-term are extremely difficult to do accurately on a regular basis.
Recency Bias: Recency bias occurs when people more easily remember and emphasize recent events rather than those that happened further in the past. After the 2007-2009 financial crisis, many investors sat in cash or loaded up on bonds because they were traumatized by the dramatic drop in stock prices. This hurt investors who needed higher returns to achieve their financial goals.
Today, after a 10-year bull market, many investors may expect the market to only go up in value. The thought of a 10% correction or 20% bear market does not even enter the psyche for many young investors. This expectation will cause many to take on much higher than appropriate risk within their portfolio. When the inevitable market pullback does occur, the mistakes made due to this bias can be devastating.
Sunk Cost Fallacy: While the public markets overwhelmingly had attractive returns, there are still pockets of poor performance for specific companies as well as private investments to which investors may have had access. The sunk cost fallacy is when we illogically fixate on the price we paid for an investment, especially when that investment has performed poorly. As a result of the sunk cost effect, we may irrationally hang on to a losing position with the hope that it will eventually return to the price we paid for it.
As most people will admit, hope is not a strategy. Furthermore, holding on to a bad investment with the expectation that you will one day be “made whole” is not sound logic. A far better approach is to plan ahead before one makes an investment regarding how much money they are willing to commit to a particular opportunity. In effect, the investor is putting guardrails on this investment. If he does lose money, it will be much more manageable, because no further capital will be committed.
Confirmation Bias: Confirmation bias is particularly important to be mindful of during an election year. This bias is the fact that people are naturally drawn to information or ideas that validate their own existing beliefs and opinions. We see this frequently in the realm of politics, where there is a tendency to only watch and read news sources that represent one’s own beliefs while muting, blocking or ignoring any other information to the contrary.
This same behavior manifests itself in the investing world as well. Investors may purchase a stock because they love that company’s products, mission, or admire the CEO. Since they have such a strong appreciation for the company, they will only seek out information that supports the solid company thesis while ignoring all other data. This can lead to developing too concentrated of a position in a company, sticking to an irrational thesis, or make costly decisions fueled by emotions.
Resulting Fallacy: Retired professional poker player Annie Duke (who also happens to have a Ph.D. in psychology) popularized the concept of “resulting.” Duke points out that we typically judge a decision based on the results. Resulting is the bias to believe that if we have a successful outcome, we’ve made a good decision. However, if we have an unsuccessful outcome, it was a bad decision. In reality, we can experience a good outcome based on a poor decision or we can experience a bad outcome even though we made a good decision. Humans tend to underestimate how much luck plays into our lives.
In a year where the markets did so well, many may be led to believe that they are brilliant investors. They may have actually made terrible investment decisions, but the overall market increase can blind them to the flaws in their investment strategy. At the start of a new year, it’s worth reviewing your investments, overall allocation and financial plan to determine if you are making prudent decisions as they relate to your finances. The market may have bailed out your bad decisions this year, but who knows what’s in store for investors in the year to come?
Methods to Overcome Cognitive Biases
There are several ways to overcome the many cognitive biases investors face by introducing systematic controls and automations into their investment process. These include dollar-cost averaging, rebalancing, diversification and setting up portfolio review days.
Dollar-cost averaging: Dollar-cost averaging (DCA) is the strategy of spacing out your investment purchases by adding money at regular intervals and in equal amounts. The benefit to this approach is that it ensures investors don’t invest all their available money at the market high. Additionally, it also protects investors who may get “cold feet” after a big market downturn, who normally couldn’t motivate themselves to add money to their portfolio at that time.
DCA happens effortlessly in one’s 401(k) plan; once an employee enrolls, money is automatically taken out of every paycheck and added to the investments. This strategy should also be set up for one’s taxable account by working with your brokerage firm to arrange for automatic withdrawals from one’s checking account to go into their investment account.
Systematic Rebalancing: Rebalancing is the process of readjusting the weightings of a portfolio as the asset classes go up or down over time. When a portfolio is rebalanced, the investor is buying or selling assets in order to maintain their original asset allocation, which is based on their risk tolerance.
Similar to DCA, this can also be set up to happen automatically. Some may have rebalancing occur at set dates throughout the year. Other investors may prefer their portfolio rebalance once a position grows or shrinks beyond a certain predetermined level. It’s best to speak to your financial adviser to determine which approach is best suited for your needs. Regardless of the approach, the act of rebalancing has the dual benefit of preventing investors from developing too concentrated a position in any single asset and automatically buying assets that have fallen in price while selling higher-priced assets (i.e., buy low, sell high).
Diversification: A diversified portfolio is one that is made up of various assets, such as stocks, bonds, commodities and real estate. Diversification allows investors to earn the highest return for the least risk, because each asset reacts differently to various economic, geopolitical and financial scenarios.
In a decade where the U.S. market has trounced the rest of the world, it is tempting to keep all your assets in American-based companies. That being said, embracing the concept of global diversification ensures that investors will minimize the impact of any unfavorable events and keep the volatility within their portfolio more muted. Minimizing volatility also keeps one’s emotional reactions in check.
Portfolio Review Days: As I like to remind my clients, checking one’s portfolio frequently will not improve its performance. It will only drive the investor crazy as they watch every market gyration. A far better approach is to set designated time(s) throughout the year to review investments. This will allow investors to avoid the emotional roller coaster of checking the daily price movements. It will also keep them focused on their long-term goals instead of short-term events that really don’t matter.
Most investors, regardless of experience or intellect, are hardwired to make irrational decisions. The best way to overcome their cognitive biases is by instituting the above techniques. The common element of all these strategies is that they remove emotion from the investment process. Minimizing emotional reactions to market conditions will assist investors in making prudent personal finance decisions in 2020.
Disclaimer: This article authored by Jonathan Shenkman a financial adviser at Oppenheimer & Co. Inc. The information set forth herein has been derived from sources believed to be reliable and does not purport to be a complete analysis of market segments discussed. Opinions expressed herein are subject to change without notice. Oppenheimer & Co. Inc. does not provide legal or tax advice. Opinions expressed are not intended to be a forecast of future events, a guarantee of future results, and investment advice.
About the Author
Associate Director - Investments, Oppenheimer and Co. Inc.
Jonathan Shenkman is a financial adviser, portfolio manager and the founder of the Shenkman Private Client Group of Oppenheimer & Co. Inc. He is experienced in developing creative strategies that allow his clients to achieve their retirement, estate and philanthropic objectives.