Investing can be an emotional business.
Traditional finance is not enough, your behavior matters too. It is hard to avoid having an emotional reaction to portfolio volatility, whether it be fear and anxiety to losses, or confidence and elation to gains.
Central to our investment philosophy is a goal to favor steadier and less volatile investments. Nonetheless, we know that we can’t completely shelter you from the cycles of market optimism and pessimism, and the emotional impact they bring. But what we can do is help you understand your behavioral investment biases, and help you invest in a portfolio allocation that you can feel more comfortable in throughout full market cycles.
There are many behavioral biases that investors embrace when making financial decisions. We believe that you should take the time to understand your own behavior, and coolly decide whether or not your investment decisions are the result of clear, long-term decision-making or driven by one or more of these biases.
Loss Aversion Bias
For most of us, losses may feel more painful to bear than gains may feel a pleasure to experience. Experiences of large drawdowns are scarred across our memories, but rarely do memories of gains leave as much of a mark. Every person weighs this loss-to-gains ratio differently, but big losses may be generally painful experiences, and everyone has their own tolerance level. It’s primarily because of loss-aversion that we uphold an investment philosophy that pursues steady and consistent growth, and why we think it’s so important for you to invest at a risk-level in which you’re comfortable.
Status Quo Bias
Change can be hard. And that’s just as true for investment decisions as for anything else. Quite often, you may find yourself arguing consistently for leaving a portfolio as is, and making as few alterations as possible. It’s easy to become emotionally attached to your portfolio holdings; even when the rational argument is clearly for change, you may find yourself trying to justify why it’s better to hold onto the winners or losers in your portfolio. The status-quo bias is one of the most challenging biases that we’ve encountered, and we encourage all investors (ourselves included) to regularly review their portfolios, and rationally assess whether every holding is still attractive by virtue of its original investment thesis, and if it’s still consistent with the portfolio’s long-term objectives.
If you find yourself focusing more on negative news than positive news, you’re not alone. The negativity bias refers to the idea that even when equal, negative developments leave more of an impact on your emotional state than positive developments. The negativity bias has an interesting way of manifesting itself when it comes to investing; quite often, you may find yourself coming up with many reasons why stock markets may fall – such as a bad piece of economic news, social unrest, or political elections – and selling your investments to protect them from macroeconomic uncertainty. As hard as it is to avoid voices of pessimism when investing – and it certainly doesn’t help that the financial news media seems to focus more heavily on bearish developments than positive ones – staying permanently out of the market has rarely been a winning strategy.
Historical polling of stock market sentiment has revealed an interesting insight: during rising markets, most investors are bullish and forecast further gains; during falling markets, most investors are bearish and forecast further losses. This is a powerful display of the recency bias in full effect, as forecasts into the future are often just extrapolations based on current trends. These types of extrapolations can lead to performance chasing, with many investors piling into assets purely because they have risen in the recent past. Quite often, this type of frenzied buying or selling signals the end of bull or bear markets, leaving people who bought or sold near the end of market cycles with large losses or huge opportunity costs.
If you’ve built your own stock portfolio before and done your own research, chances are you may have at times fallen into the confirmation bias trap. Investors often find themselves drawn to research that acts to merely confirm previously held convictions. So if you were interested in buying Apple stock and wanted to do more research first, you may find yourself drawn to articles that forecast booming iPhone sales growth, rather than articles that present a less optimistic case for Apple as an investment. Research and knowledge are very important when it comes to making investment decisions, but it’s important to be balanced in your research process, and understand the pros and cons of your investments.
One element to long-term success in investing is to design a sound investment plan, and then establish the fortitude and discipline to adhere to the plan over the full market cycles. It’s not always easy to do this, but we strive to help you stay the course.