Broker Check

Beware of Emotional Bias During Market Corrections

| July 06, 2022
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One of an investment advisor's primary roles is helping investors avoid expensive mistakes. The field of behavioral finance is focused on identifying and explaining cognitive biases that motivate investors to make irrational investment decisions and behave in financially detrimental ways. Investment companies and independent research firms like DALBAR also conduct extensive long term studies of investor behavior in order to understand common biases that lead to emotional decisions. In my experience the two most common biases that lead to major mistakes are referred to as 'anchoring' and 'recency'.  Both tend to read their ugly heads during market corrections like these.  

Do you find yourself focusing on how much your account has recently declined rather than your long term results?  “Anchoring Bias,” is where investors arbitrarily anchor expectations to market highs instead of taking a holistic view of their progress towards their long-term financial goals. Anchoring initiates a destructive cycle of emotions that begins when an investor creates a psychological benchmark based upon the the highest value their accounts reached (e.g. January 2022). This causes investors to focus on short term declines and ignore their long term results.  This elevates anxiety during normal market pullbacks and corrections. This, in turn, motivates investors to panic and abandon proven long term processes (selling low).  

Ever notice how commercials promoting the purchase of gold become more interesting during a market correction? "Recency Bias" is the tendency to place too much emphasis on experiences that are freshest in your memory—even if they are not the most relevant or reliable. This bias may lead investors to think that a current stock market downturn or rally will extend into the future. Unfortunately, you can't use past results to predict which investments, industries, economic sectors, or asset classes will perform best this year.  The Callan chart below, for example, allows us to consider how various asset classes performed each year.  Using the results for any given year, try to predict which asset classes perform best the following year.  Doesn't work does it?  There's a reason we always say, 'past performance is not indicative of future results'.  There's a reason diversification is important.   

Conclusions

There are many cognitive biases that can lead investors to make short-term decisions that deviate from their financial plans. The take away here is that successful investors don't anchor their expectations to market highs or try to predict the future based upon recent events.  


Investors cannot directly invest in indices. Past performance does not guarantee future results.

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