The stock market is jittery over worries of an economic slowdown. A structural or cyclical slowdown, the threat of war, global issues such as Brexit or the tariff battles, the price of crude, changing interest rates – all these are events that could impact the market. And you and I can do sweet nothing about it.
Yet, those are not the only dangers. There are behavioural biases that can wreak havoc with our portfolio. Let’s turn the spotlight onto those.
Why? Simply because they are within our control, and have a high probability of affecting our decisions, which in turn has a meaningful impact on our portfolio.
Adam McCullough, an analyst on Morningstar’s manager research team in Chicago, covering passive strategies, throws clarity on this issue.
Emotional biases
Emotional biases stem from impulse or intuition and lead to faulty reasoning owing to the influence of feelings such as fear, greed, or remorse. They are difficult to manage because they stem from impulse rather than miscalculation or interpretation of information (as in the case of cognitive biases mentioned later). For example, fear of pain from investment losses could lead us to sell out of the market after it crashes.
This is often a poor decision because valuations are more attractive following market downturns, which can lead to better future returns. On the flip side, fear of missing out could induce counterproductive performance-chasing.
The decision to buy once prices are already high is another suboptimal investing decision because high prices can lead to less attractive valuations and returns going forward. In any case, doing what you wish you would have done in the past is rarely a recipe for investment success.
Morningstar’s Mind the Gap measures the cost of bad timing. This gap is simply the fund returns that investors missed out on owing to poor investment timing decisions, likely performance-chasing. The study aims at quantifying the phenomenon of investors behaving badly because of emotionally fueled decisions.
Overcoming emotionally driven decisions is difficult. Investing to your "optimal" risk-based asset allocation isn’t useful if you can’t stick with it during rough patches in the market.
Cognitive biases
Cognitive errors stem from poor information processing and overconfidence in our ability to predict or influence market outcomes, leading to bad decisions. For example, resisting the urge to trade when faced with new information can be tough to overcome. But you’re likely better off not trading based on "new" information that you read in the financial press. Since everyone has access to that news, it probably won’t lead to market-beating performance. Frequent trading can lead to excessive transaction costs or realised taxes, which detract from performance.
If you find yourself trading frequently, remember there’s always someone on the other side. Consider what they might know that you don’t. It should also be sobering that most professional money managers, with all their time and considerable resources dedicated to their craft, don’t beat the market.
Cognitive errors can lead to the impression that we can take actions to beat the market, even when the odds are long. The good news is that cognitive errors are easier to address than emotional biases because they represent limits in logic or calculations rather than deeply seeded impulses.
Checking your decision-making logic and finding gaps in thinking are often the best ways to avoid cognitive errors.
The following strategies will help mitigate their effects.
1. Hit pause
Often times when making an investing decision, the benefits of waiting a day or a week to make a decision outweigh the penalty for not acting fast. Slowing down the decision-making process will allow the time to collect necessary information to make a more informed decision. Sometimes, the best thing to do is nothing at all.
2. Keep an investment journal
Documenting your thought process leading up to an investment decision can help keep yourself in check. Use consistent sections in your journal to create a time series of decisions to find where you consistently make strong or poor decisions.
For example, you could habitually overestimate the risks of an investment decision. Knowing this information could help you adapt future decisions to incorporate this known cognitive bias.
Keeping a journal can also help you keep track of skillful versus (un)lucky decisions. Did the decision pay off for the reasons that you had anticipated or because of events that you hadn’t considered?
3. Have a devil’s advocate
All human beings have a natural tendency to seek out evidence which is supportive of our previously held opinions.
A devil’s advocate is expressly charged with making the “bear case” on both current holdings and prospective investments. This will ensure that your investment thesis is challenged and vetted through an objective and skeptical lens. It will also serve to highlight any risk that may be overlooked or deemphasized.
Find a friend, financial adviser, or family member to check your investment logic and highlight your blind spots. The goal here is to help strengthen your thinking before making the decision. The best candidates for this role are those that exhibit sound logical thinking, aren’t afraid to point out when you’re wrong, and are willing to put in the time.
This is a two-way street. An investing partner will appreciate it if you exhibit the same characteristics when serving as a devil’s advocate for them.
4. Be smart with your asset allocation
Depending on your level of wealth and standard of living, emotional biases may be best managed by modifying your asset allocation. For example, you could shift toward an asset allocation that’s more conservative (for example, tilting more heavily toward bonds and away from stocks) than the risk level that you ought to be able to tolerate.
The higher your level of wealth and lower your standard of living, the more cushion you have to deviate from your optimal asset allocation. Modifying your asset allocation to adapt to your emotional biases could improve your investment outcome because you’re more likely to stick with a more conservative allocation in turbulent times.
Take it seriously
Emotional biases are more difficult to overcome than cognitive biases because it’s tough to control emotional responses to the experience of losing or making money.
Cognitive errors stem from faulty information processing or recall. These are split between two types.
First is belief perseverance, which is the tendency to irrationally stick with current beliefs. These decision-making errors could stem from selective exposure, perception, or retention of new information.
Processing errors are the second type. Instead of failing to adjust to new information, these errors are caused by shortcuts that we use to make decisions quickly. Cognitive errors represent the limits of the human mind and tend to be easier to correct than emotional biases.
All investors will exhibit some of these biases at some point in their investment career. While it’s hard to avoid these biases, it’s important to take steps to mitigate their impact. If unchecked, they could torpedo your portfolio.
Read more on the subject of behavioural finance here.
