Keeping Emotions in Check: Behavioral Finance Basics

While 2020 has been a year of many firsts, there are some things that never change, like letting our behavioral biases guide our investing decisions.

The current market backdrop feeds into some of the most common behavioral biases that have the potential to hurt investors. Advisors can help their clients stay the course if they make them aware of such biases and put them in context with the current climate. Consider some of the biases at work:

Overconfidence suggests that we tend to overestimate the accuracy of our predictions. For an investor this could mean believing their knowledge of an investment is greater than it actually is.

Familiarity Bias
A familiarity bias refers to our preference for outcomes and patterns we have observed previously. Investors may not feel the need to diversify a portfolio due to the record-long bull market run that ended earlier this year, forgetting the possibility of another extended market correction going forward.

Loss Aversion
The principle behind loss aversion is that humans are aff­ected more emotionally by losses than gains. For investors, loss aversion may mean wanting to pull out of an investment due to a minor loss, despite the long-term performance or role the investment plays in a portfolio.

Information Overload
When faced with more information than the human brain has time to assimilate and process, humans adopt strategies to simplify decision making. While these strategies require less cognitive eff­ort, they may be less accurate than a more rigorous decision process. With all the information readily available today, investors may become overwhelmed, leading to panic or poor decision making.

The concept of herding refers to an individual’s desire for acceptance within their particular peer group. Investors may want to pursue a particular category or investment due to it being popular amongst family and friends.

The process of anchoring means an individual tethers their forecast to an original reference point, then fails to adjust sufficiently from that reference point when new information or evidence becomes available. An investor may have had a great first experience when investing in a specific security or investment vehicle and remain biased despite the investment not aligning with their long-term portfolio goals.

Recency Bias:
When investors exhibit recency bias, they let current market performance warp their assumptions about how markets will behave in the future. The oft-used compliance statement that “past performance is no guarantee of future results” goes right out the window.

Recency bias based on the last ten years and even the market’s movements this year might give investors a false sense of security about the trajectory of equities. For perspective: In the month of September, the S&P 500 Index started the first two days as the best start to a month in 10 years. But that quickly changed and after five days, September was off to the worst start for the month since 1987.

While behavioral impulses are hard to ignore, clients are better served when they put emotions aside and invest rationally. Long-term asset allocations to alternatives, for example, can serve as guardrails for a portfolio and help keep investors invested through market ups and downs. This is because alternatives have the potential to cushion those falls, helping portfolios recover faster so they can get back to compounding. Case in point, long/short equity strategies lost about 20 percent, on average, during the Financial Crisis, but nowhere near the losses of 50 percent or more experienced by many equity indices. More recently, long/short equity strategies lost about 12 percent during the market drawdown in February and March of this year, while the equity indices lost around 20 percent*.

Keeping behavioral instincts in check can prevent investors from acting to their detriment when the ride is too smooth or too harrowing. Hold on to the alternatives allocation. The ride is likely to remain bumpy for quite some time.

Check out our Infographic on Behavioral Finance Basics >