The link between behavioral science and the stock market is always relevant, but the conversation surrounding it becomes increasingly important in times of uncertainty, as seen in the early stages of the coronavirus pandemic. The increased volatility of the market and the feelings of anxiety that come with it can further impact our decisions. Without knowledge of behavioral science principles, such as the cognitive biases that can lead us astray and how to go about overcoming them, we may wind up making the wrong choices for all the wrong reasons.
Of course, our decision-making is not always based solely on logic even in the best of times. There are many factors that can influence the choices we make, often without us even realizing it. As an investor, checking your portfolio frequently might seem like a good way to stay on top of things. Yet, it has been shown to result in hasty, irrational decisions. By understanding the factors that can influence our decisions for the worse, we can learn how to avoid them. When it comes to the stock market, this enables us to make sound choices regarding our investments. Better choices mean better performance, and better performance means less anxiety, which in turn allows us to make better choices … and the cycle continues.
1. The power of biases
By: “Behavioral Guidance During Market Volatility: Why Managing Our Emotions May Lead To Better Investment Outcomes”, PIMCO
Just like how our physical energy becomes depleted after working our bodies, our minds can only do so much before needing a break. Although our mental resources are dedicated to important tasks, like processing the stimuli around us and making important decisions, it is not available in infinite supply. For that reason, our brain takes shortcuts that allow us to conserve that mental energy for the truly important tasks. In decision-making, these shortcuts are referred to as cognitive biases and heuristics. These are useful tools for efficient decision-making when there is not a lot at stake – for example, when deciding what to wear – but trouble may arise when we rely on biases and heuristics to make important decisions – such as how to invest our money.
One bias that can influence investors’ behavior is the recency bias. This bias refers to how we tend to remember recent events more vividly than events that occurred longer ago. As our memories of these events are more salient, we may feel that they are likely to occur again. This may cause us to change our investment behavior to align with market trends from our recent memories which are actually unrelated to future outcomes.
A second bias that investors should keep in mind is loss aversion, which describes how we tend to feel losses more acutely than gains and, as such, prefer avoiding losses to acquiring gains of equal value. As a result, investors may let their fear of losing money drive their decision-making, which can lead us to make maladaptive choices.
Another example of a bias that can influence investment behavior is the framing effect, which refers to how the manner in which information is presented to us can affect the way we evaluate that information. For example, if an investment option is presented negatively, or in terms of losses, we may be hesitant to select it. However, if an equivalent option is presented positively, or in terms of gains, we may be more willing to go for it. The way information is framed can completely change our perception of it, significantly impacting our subsequent actions.
When it comes to the decisions that matter, like choosing how to invest your money, it is important to take the time to make effortful decisions based on logic and reason, instead of taking a shortcut and risking an unfavorable outcome.
2. How to avoid emotional investing
By: Russ Wiles, “Emotions Can Mess Up An Investment Plan. Beware of 6 Irrational Ways To Make Decisions”, AZCentral, September 2020
Behavioral economists are particularly interested in why people make irrational decisions, which has led to research into the effects of different biases. It is clear that biases can lead us to make poor decisions, which raises the question of how we can avoid relying on them in decision-making – especially when it comes to major decisions, such as what to do with our money.
One simple piece of advice for avoiding succumbing to the various biases that can influence our decision-making is to be aware of them. Reading up on the factors that can sway the decisions we make about our investments can help us be more conscious about how we go about making choices in the future. For example, combining knowledge of loss aversion with research into what normal market fluctuations look like can prevent us from scrambling to avoid losses and instead allow us to make rational decisions based on the big picture.
Something else you may find useful is to write yourself a letter detailing your goals and values pertaining to your investments. When the market gets turbulent, reviewing this letter can help remind us of what’s important to us in the long-term, which can keep us grounded and prevent us from taking actions we may later regret.
A third recommendation to promote rational investment decisions is to avoid impulsivity whenever possible. If we make decisions in the heat of the moment, we are more likely to rely on biases and heuristics to guide us. Instead, take a breather and allow yourself to cool down before deciding what actions to take. This way, you will be able to use logic to make a decision, rather than succumbing to biased thinking.
3. The consequences of frequent checking
By: Mark Hulbert, “This is a sure way to make costly investing mistakes in the coronavirus crash”, Market Watch, March 2020
The plunge the stock market took as a result of the coronavirus pandemic was enough to make even the most confident investors uncertain. A common consequence of the heightened anxiety that resulted was for many investors to begin checking their portfolios far more than usual. Frequent checking feels reassuring and it can even lead us to think that we are doing ourselves a favor by being more cautious. However, all it really accomplishes is increasing our anxiety about the state of our investments.
A 1995 paper by renowned behavioral economists, Shlomo Benartzi and Richard Thaler, which was published in the Quarterly Journal of Economics, provides empirical evidence to support the theory that frequent checking is a path to poor investing. They did so by comparing a group of investors who checked their portfolios on a regular basis to a group of investors who checked their portfolios only every so often. The group of “frequent checkers” tended to have more conservative portfolios and ultimately had significantly worse performance than the “infrequent checkers” in the long-run. Thaler and Benartzi dubbed this effect “myopic loss aversion”, because it represents a metaphorical nearsightedness, or inability to look at the big picture, on the part of the investors who check their portfolios frequently.
Benartzi and Thaler’s research was conducted in the 1980s and 1990s – before the Internet gave us instant access to information on our portfolios’ performance. In fact, the people they refer to as “frequent checkers” in their paper only checked their portfolios every few months. While the ease of access to information we experience today certainly has changed things, the principle of the matter still holds. A more recent study from the National Bureau of Economic Research compared the performance of investors who check their portfolios almost constantly to the performance of those who checked once every four hours. Like Benartzi and Thaler, they uncovered the steep cost of frequent checking. Investors who checked their portfolios less frequently were significantly more likely to make risky investments and brought in profits 53% greater than those yielded by investors who constantly monitored their portfolios.
Benartzi and Thaler suggest that myopic loss aversion results from the fact that when we focus on the short-term, we experience more loss than we do when we look at the long-term. According to the theory of loss aversion, losses affect us more than gains, so we are motivated to avoid them at all costs. This can cause us to react to even the smallest fluctuations in the stock market. Their recommendation? You can probably guess – check your portfolio less often. It can stop you from making choices you will come to regret and has the potential to reduce your stress about your investments, which can make you a better investor in the long run.
4. Economic bubbles … and what happens when they burst
By: Emily Graffeo, “A majority of investors believe the stock market is in a bubble – and many fear a recession, according to an E*Trade survey”, Business Insider, January 2021.
When it comes to the stock market, the term “bubble” refers to the rapid inflation of the market value of a good or service, with its price surpassing its intrinsic value. At first, a financial bubble is exciting, and may even be accompanied by a state of euphoria. As prices start to climb higher and higher, some investors feel that things are about to come to an end and sell their shares before the bubble bursts. Ultimately, prices get so high that no one is willing to buy anymore and other investors notice that some of their peers have begun to pull out. A state of panic sets in as investors scramble to sell as quickly as possible, while prices plummet. This crash is referred to as the bubble bursting. At the extreme, financial bubbles can give way to recessions, as was seen in the early 2000s when the real estate bubble burst.
Examples of this pattern of behavior can be found throughout history. Now, people are starting to wonder whether it is happening again. At the start of 2021, a group of E*Trade surveyed a sample of 904 active investors, 66% of whom stated that they feel that the stock market has achieved bubble status. On top of that, another 26% of the investors surveyed responded that, while they felt that the market is not yet in a bubble, it is on its way there. The market as a whole is above average, but the Tesla stock in particular increased at an astronomical rate over the past year. Concerns over a financial bubble are accompanied by worries about entering another recession – something that 32% of investors surveyed listed as the main risk to their portfolio at the moment.