Emotional Bias Can Impact Investment Decision Making
We all remember March, 2020, when much of the world shut down. The markets were on a roller coaster ride to put it mildly, and investor emotions were off the charts.
The uncertainty that COVID-19 brought to the world was indeed next level. Face masks and social distancing were prevalent topics as maintaining our health became even more of a focus than normal.
Our minds wandered to the health of our portfolios as Q1 concluded with the S&P 500 down 20% in just the first 3 months of the year.
Emotional Bias. What is it and how does it affect me financially?
Wikipedia defines emotional bias as a distortion in cognition and decision making due to emotional factors. Translation — human beings often make bad decisions when emotions are the catalyst behind their choices.
According to a Vanguard study, investors who deviated from their initial retirement fund investment or didn’t stay their course, trailed the target-date fund benchmark by 150 bps or 1.5%. That’s a lot.
At CG Capital, an advisory firm which I co-founded in upstate New York, we were introduced to a fair number of people last year who placed trades in their portfolios largely in response to emotional bias. Some of the back testing showed significant losses as a result of these actions. Had they stayed the course, the S&P went from -20% at the end of Q1 to +16.26% by the end of 2020.
To put a dollar number on this, let’s look at an example. If we assume an investor with $1 million in their 401(k) converted from an S&P 500 fund to cash at the end of Q1, their account value would have equaled approximately (excluding any fees) $800,000 on March 31, 2020. Let’s estimate a generous 1% earned on those funds allocated to cash for the rest of 2020. They finish the year with a balance of $808,000.
Now, let’s assume this investor didn’t convert to cash (and tamed their emotional bias along the way). That same $1 million on January 1, 2020 would have been worth $1,162,600 on December 31, 2020. That’s a difference of $354,600!
If there is so much information out there as to the efficacy of staying the course, why don’t we?
Before we beat ourselves up too much, human beings are emotional by nature. Consequently, we aren’t always the best stewards of our own savings. In fact, there is a city in the Nevada desert that profits on this regularly. We can’t think rationally when worry and loss are our prevalent thoughts.
We get protective, lose faith, and take action to eliminate the negative emotions we are experiencing. Then and only then do we feel a sense of relief and safety.
What happens next? Sometimes we’ll realize that our desire to avoid the source of our fear or negative emotion, i.e., market volatility in this writing, led us to counterproductive decision making. Yet at other times, we don’t have this realization and the behavior pattern becomes recurring.
How can we change this mindset?
Having a simple awareness of our tendency can often lead us to be more prepared for our emotional response the next time we are tempted. And there will be a next time.
Perspective can help, too. If we reference an historical chart of the stock market dating back to the 1920s and look closely, the frequent ups and downs can be dizzying and cause us more angst. However, if we step back and look at the trend in the chart, we’ll notice an approximate 45-degree angle that steadily increases from left to right. This can be an effective image to think about the next time we experience a bumpy road as part of our investor journey. After all, it’s time in and not timing the market that is most important.
Bank of America looked at the impact of missing the market’s best days. Looking at data going as far back as 1930, their findings concluded that if an investor missed the S&P 500′s 10 best days each decade, their total return would equate to 28%. If, on the other hand, the investor held steady during those inevitable ups and downs, their return would have been 17,715%. Take this inward and don’t lose it; let these numbers serve as the raw material you need for a shift in your mindset.
Some other helpful tips:
- Consider working more closely with your financial advisor. They can be your source of strength and confidence when you need those the most. To this end, the Vanguard study I alluded to earlier found that behavioral coaching can add 1%-2% in net return. Fairly substantive.
- Diversification. Yes, I know it’s a worn-out term but nonetheless important. If you know that your portfolio offers you an appropriate balance of equities and fixed income given your risk tolerance, you’ll be less likely to have an emotional response during volatile periods.
- Use information sources for just that – information. Not for guidance with your decision making.
- Don’t listen to your friends. They’ll likely only tell you of their wins anyway.
- Avoid the temptation to follow “hot” stocks or trends. Stay true to your plan.
We endure many emotional ups and downs as investors. This can’t really be avoided if you have equity exposure in your portfolio. Acknowledging this truth can be helpful and cause you less surprise the next time volatility enters your space.
If your allocation is aligned with the purpose it has in serving you, this can also make volatility more palatable.