- How does behavioral economics work and what are its potential benefits and pitfalls when investing?
- Behavioral economics can help investors define their goals and gain a better understanding of financial market moves.
- Learn new tools to use for financial planning in times of uncertainty and volatility.
As I sit here reflecting on the twilight zone that is 2020, just ahead of the U.S. presidential election, it’s often been difficult to know which way is up or down, and at times even more difficult to keep from getting emotional about what’s happening in our world. While we try to manage the best that we can, the reality is that all the sheltering in place, lack of traditional social engagement, homeschooling, and social and political unrest are starting to wear on even the most optimistic of us. This is because we are, after all, human. Studying what drives human behavior, in times like these, interestingly can be very valuable in explaining capital market events that aren’t explained by traditional finance models and that assume humans act rationally and have self-control. There is a whole field of study called behavioral finance that examines how human psychology triggers investor behaviors that can directly drive market volatility. And volatility has been the name of the game in 2020, as equity markets declined steeply in the spring – which was extreme relative to past declines - followed by a dramatic rebound and then further volatility throughout the summer.
Understanding basic concepts of behavioral finance can help us achieve a better understanding of two important topics: 1) what drives our investor thinking and contributes to our idiosyncrasies and 2) what’s going on in the stock market. And I would suggest that anything that helps us make sense of the madness (especially when it comes to this year!) should be hugely welcome.
Unless you’ve been living under a rock for the past eight months, you have been affected by general uncertainty about the pandemic and know that it has been at the epicenter of the economic distress that we are in the midst of. The IMF forecasts that the world economy will face the worst recession since the Great Depression with a total 2020-2021 output loss exceeding $9 trillion. That outlook is certainly enough to cause uncertainty and fear and, as I’ve said many times before, markets hate uncertainty. And it’s how these uncertainties play out, given that people don’t always act in rational ways and can have biases and are prone to cognitive errors, that behavioral finance seeks to explain. So let’s delve into a little human psychology and discuss what drives thinking in times like these:
1) Overconfidence. It’s easy to understand how overconfidence can have its pitfalls. And it is one of the main drivers of stock price volatility that we’ve observed this year. The tendency to miscalibrate information, which is closely related to being overconfident, is also very relevant when thinking about financial markets.
2) Being better than average. This effect is observed when people consider themselves to be better or have better insight than others like them. This thinking tends to correspond with higher trading volumes in the market because people may think they have better information than others. This may also happen in the corporate setting, as well, where overconfident managers potentially overestimate the company’s abilities to meet challenges as they don’t understand the full risk facing the business.
3) Illusion of control. This situation describes people believing that they may be able to influence events that they have absolutely no control over whatsoever. We saw this in the 2008 Global Financial Crisis when overconfident risk management models essentially blew up, causing the financial bubble to burst.
4) Herd mentality. In this behavior, people tend to throw out the good information that they may have and instead just follow what they are observing others doing. Throw in a bit of Fear of Missing Out (FOMO) and you can see why this can be quite dangerous. We saw this play out in the 1997 Asian Financial Crisis.
Navigating these times is certainly not easy, and it helps to review relevant data points to understand the full picture. We can’t always look to the tried and true methods or look for things to happen exactly as they have in the past. When it comes to investing, we must be aware of our psychological shortcomings if we are to avoid undesirable outcomes. So, what can you do to recognize what prompts your own thinking and take control of things that you can?
1) Consider a news filter. As difficult as it may sound, I can’t stress how critical this is. We all know that these days are filled with information overload. It’s natural, as an investor, to be glued to the news especially when things are volatile. However, note that we live in a world of endless information, real and fake. Just because you have more information, doesn’t automatically mean you have better information or understand the larger context. Other biases, such as “recency bias” and “confirmation bias”, are additional behavioral finance concepts that play out when we tend to react strongly to the most recent piece of information that we have heard, and assume that it is the best course. Due to confirmation bias, we tend to create a potentially dangerous feedback loop in which we may end up focusing on the information that supports what we want to believe. You need to create your own personal filter or find a sounding board or trusted advisor that can help assess the situation.
2) Know your risk and risk tolerance. Seasoned investors generally have a good sense of what risks they are taking and know what they can stomach. For those newer to investing, it’s worth taking the time to fully understand all the risks. It’s often helpful to run multiple scenarios to look at things in the best, worst or neutral cases and understand what factors drive these scenarios to happen and how they might impact your portfolio. This is a powerful exercise in that it helps one to be able to better manage expectations. I’ve found that many people think they can take on more risk than they actually should, especially in the wake of one of the longest bull markets in history.
3) Diversify. This may sound obvious and something that’s been said many times before, but it’s much harder to do in practice, especially because people tend to prefer being invested in things that they are familiar with or that they believe they fully understand. However, this often leads to outsized concentrated positions in single companies or industries, creating a risky proposition, particularly in these volatile times. Diversification is effective because it avoids putting all the risk in one place. It spreads it out over different companies, industries, or asset classes. Having a variety of (ideally uncorrelated) investments means that no two should perform exactly the same way in any particular market environment, which means you are reducing risk per unit of return. The goal of investing in this way is to provide a smoother ride.
Admittedly, there is no silver bullet to navigating these challenging times, but being aware of some of the pitfalls, coupled with taking active steps to position yourself for the future, is well worth the effort.