Biases During Market Volatility

Jun 8, 2020 Willow Creek Wealth Management Posted in Articles

Research scientists sometimes refer to the brain’s thought process as having two “systems,” as famously theorized in Nobel laureate Daniel Kahneman’s book “Thinking, Fast and Slow.” Both modes of thinking are essential and important in their own right, but they operate quite differently. System 1 is fast, instinctual, and emotional, helping us to make everyday decisions and react quickly when we need to. System 2 is slower, more deliberate, and logical, helping us with more complex tasks and decision making. Both systems use shortcuts to make decisions more quickly. Shortcuts can be efficient and helpful, but they can also lead to deviation from rational judgment. These “cognitive biases“ pop up when our natural shortcuts lead us to the wrong conclusions and can affect our financial decisions in unfortunate ways, especially during an emotionally charged crisis. How can we recognize negative emotional biases before they get us into trouble? The emotional roller-coaster of a crisis such as the coronavirus creates fatigue and distraction that causes us to depend on our System 1 instinctual brain more often. COVID-19, in particular, has disrupted our normal schedule and habits. There are fewer easy decisions, so be aware that the more you use System 1, the more prone you will be to behavioral biases. While researchers have identified hundreds of biases, here are a few that are more prevalent during market volatility.

Identifying bias

The human brain has an easier time remembering what just happened, so when we try to predict future market performance, we associate it with recent market activities rather than the historical past.

Tip: Don’t let recency bias convince you that a current market drop means that the market will continue dropping indefinitely. Historically markets are in negative territory only one-third of the time, so the prudent investor stays-the-course.

Looking for validation from what others are doing has many useful applications in life. However, in times of market uncertainty, the crowd may be overreacting and going in the wrong direction. There is a strong human need for acceptance, but data shows the average investor does not beat the market consistently. Just because everyone is doing something doesn’t make it a good decision for you.

Tip: Refocus on your long-term goals. Historically, markets have moved back up quickly and in a very few days.

In periods of market volatility, taking action can, in and of itself, feel irresistibly comforting. Win or lose, doing something can feel deceptively constructive.

Tip: Remember that you have already taken action by creating a long-term investment plan and hiring a professional to help you stick with it.

It is human nature to be unrealistically optimistic about our chances of success. Unfortunately, this sense of personal “reality” can lead to rash decision making.

Tip: Consider that fear presents itself in different ways. A market downturn is a good time to rebalance your portfolio with opportunistic buying but not necessarily to drastically increase your level of risk.

In keeping with the definition of a cognitive bias as a deviation from rational judgment, confirmation bias is the tendency of the mind to pay more attention to information that supports our beliefs and opinions.

Tip: Be careful when you listen to media outlets. Do research that gives you a broad view of a subject involving different perspectives.

Loss aversion

A very common bias experienced by investors is that of a loss feeling twice as bad as a gain. Strong emotions of loss and grief make it difficult to make prudent financial decisions.

Tip: Set a cool-down period for yourself for times of high emotional tension. For example, agree to wait a day or two before taking action so System 2, the rational part of your brain, can catch up.

In summary, it is perfectly normal to experience emotional biases ­— especially during market volatility and a major health crisis such as we are experiencing. But by being aware of the biases you are prone to and checking with your adviser or applying a cool-down period, you can help ensure that you are making rational financial decisions in keeping with your long-term investment plan.