Ways to outsmart your cognitive biases
As markets continue to be wax and wane due to ongoing coronavirus fears and subdued employment and economic recovery numbers, it seems timely to remind ourselves of the types of behavioural and emotional biases that could lead to potentially risky investment behaviour, and how you can avoid them.
As human beings we are not well wired for the rational, dispassionate approach that economists love to think of as "normal".
Loss aversion refers to a bias in human psychology where we tend to prefer avoiding loss than acquiring equivalent gains. The principle here is that we'd rather not lose $100 than to gain $100. We tend to focus more on what we might lose, rather than on what we might get. The fear of loss can often reduce our ability to stay the course.
This was evident during the period of market volatility in late March, which saw some investors cashing out in a bid to protect a portfolio's existing value. By realising those losses at that point in time, it meant that those same investors were less likely to have benefited when the Australian sharemarket quickly moved back and regained much of those initial losses.
A way of addressing this is to frame your portfolio gains and losses as wide as possible and over a long term horizon and not take a narrow view at one point in time. For example if you focused on just your Australian share investments you had an emotional roller coaster ride through March/April. But what would it have looked like if you total portfolio view – including international shares, bonds and even your home in your total portfolio view.
Vanguard's Index Chart illustrates the value of a longer-term approach well with historical data showing that markets fluctuate from year to year but those who ignore the emotional swirl of short-term market conditions are inevitably rewarded for their patience and discipline in the long term.
This bias entails looking for information that supports our beliefs or choices. And during an ongoing period of market volatility, it can be particularly tempting to start thinking about changing your investment behaviour and in the process, seek out information that we think will help us make better investment decisions in the short term.
But consider this - we are told that the world is bracing for a second wave of coronavirus infections but in the same breath, we are also told that there is an 80 per cent chance of a vaccine before year's end. Would you sell your investments now to avoid another market correction because you are convinced that a second wave of infections is on its way, or would you hold on to your investments because you know for sure that a vaccine is almost here?
The reality is, we have no way of knowing which of the two scenarios will eventuate. Actively seeking out information that confirms your thoughts on any of the scenarios, or subsequently ignoring any data that suggests otherwise and then making an investment decision based on current information, is likely to hinder rather than help achieve your investment goals.
Again, the challenge is to be disciplined and stay the course and understand what you can – and what you cannot - control. In keeping to the investment strategy that you have carefully put in place – one that will endure in both the boon of a bull market and the stress of a bear market – you're still on track to achieve your investment goals over your investment horizon.
According to the best minds in psychology, herd behaviour is particularly relevant in the domain of finance and has on occasion, represented a major cause of speculative bubbles. During the March market volatility, it was not uncommon to hear many declare that now is the best time to invest in technology-related shares because they were booming or to invest in the health sector because a vaccine is imminent.
Are you buying bonds and moving into cash because your well-meaning uncle who's not far off from retirement advised you to do what he did, or are you buying equities because your much younger neighbour is convinced that this is 'the way to go'?
Rather than follow the crowd when making investment decisions that impact you alone and not the herd, you should take into account your unique circumstances and investment goals when executing on your strategy.
One strategy that you could deploy during volatile times is to spread your investments over a certain period of time. Rather than time the markets, you could instead try the dollar cost average method by putting regular contributions towards your investments until you get to your target asset allocation.
Cognitive biases are often hard to detect because they occur so naturally but learning and recognising how they can affect your decision making, especially in times of uncertainty, will be useful for every investor. And remember, this is much easier to do if you have taken the time to create an investment strategy tailored to your own risk appetite and investment objectives.
Understanding that we are all subject to biases as an investor is a powerful argument for the value of having a written financial plan that captures why you are investing and what are your personal goals. Then at times of market stress it can be retrieved from the filing cabinet (either real or digital) and used to either adjust or simply stay on course, accepting there may be well be some rough weather ahead.
Head of Corporate Affairs at Vanguard.
16 June 2020