During the Covid-19 crisis, as in all crises that affect our money, investors experience extremes in emotions. Often times individual investors believe that the current market crisis will wipe them out financially. In those circumstances our job is comfort them, to talk them down from the ledge and prevent them from taking action they will regret later.
When markets are experiencing extreme volatility, it results in many individuals experiencing extreme stress. During these periods of extreme stress individuals are more prone to not think about the long-term implications of their actions but rather take short term actions to “make them feel better” to relieve the stress. When experiencing very high stress, decisions tend to be emotional rather than reasoned, thoughtful decisions. For investors with long-term goals this is a problem.
The decisions individuals make when experiencing extreme stress often are influenced by what is referred to as “financial behavioral biases.” The decisions people make as a result of these behavioral biases may bring the individual investors short term relief from the market volatility; however, this relief comes at the expense of achieving their long-term goals.
Understanding behavioral biases and how they impact decision making is important to help investors accomplish their long-term goals. A recent Morningstar conference discussed behavioral biases and investing. Although there are many biases that affect investor behavior, the Morningstar panelists focused on a few that have been particularly prevalent in the time of COVID-19. The following are 4 of the most common investor biases.
Loss Aversion Bias: Investors are more sensitive to losses than to future gains. This results in investors placing more weight on bad news then good news. Some studies indicate people weigh losses more than twice as heavily as potential gains. According to Morningstar, research revealed that a person’s risk tolerance depends primarily on recent market performance. In other words, the amount of an individual’s loss aversion (or the amount of “acceptable” loss) is based on how the market has performed over the short term. Since investing by definition has a long-term objective; focusing on short term results is counterproductive.
Recency Bias: People have short memories and recall recent events more clearly than those in the past. Recency bias is our habit of giving too much emphasis to events and information that we experienced recently. Relying on recent events in making investing decisions is very dangerous. During periods when the market is advancing, investors forget about prior market losses which inevitably causes them to take on more investment risk then they are comfortable accepting. The same phenomenon occurs during periods of market losses. In those cases, investors tend to sell as the market drops because they believe the losses will continue. Recency bias causes investors to over emphasize short-term performance at the expense of long-term goals.
Overconfidence Bias: It is common for people to inflate their abilities whether it is driving, sports, intelligence or even investing. Overconfidence bias in investing results in investors overvaluing their understanding of the markets and underestimating risk and therefore failing to properly diversify their investments. According to Morningstar’s research, men are more confident than women when it comes to investing, even though it has been shown that women have higher investment returns and lower portfolio turnover then men.
Investors who are overconfident tend to believe in their superior stock market selection and their ability to “time” the market. These investors usually are very disappointed as they underperform the market over the long term.
Confirmation Bias: Confirmation bias is the tendency to put more weight to information and opinions that confirms previously existing beliefs. This bias is a problem because it causes investors to ignore potentially useful facts and information that don’t align with their own opinions and therefore results in investing decisions based on their own biases.
Confirmation bias is a source of investor overconfidence and helps explain why the bulls tend to remain bullish, and the bears tend to remain bearish regardless of what is happening in the market. Confirmation bias helps explain why investors do not always behave rationally.
Every investor experiences these biases during their lifetime. Successful investors are those who do not allow biases to influence their decision making which then allows them to achieve their goals. The more investors know about these biases, the less likely they are to fall victim to their influences. However, if you are having trouble fighting them off (like many investors do), then it might be time to consider using a professional like Bloom Advisors to help you stay on track. For a free consultation, please contact us at email@example.com or (248) 932-5200.