The size, speed, and frequency of shifts in the market this year have been enough to make many investors reel, and reeling from the markets tends to shift a person away from their standard decision making into emotional decision making. Emotional investing may not be a new idea, yet the associated feeling still feels new to many of us any time they happen.
People don’t always act rationally, and they don’t always invest rationally either. Here are a few recognizable “emotional investing” behaviors that might cause one to act (or not act).
Not the best reason to act – Recency bias or a Hair Trigger to the news
Markets move on news, but sometimes the first market response is an overreaction or underreaction, as not all information is known yet. Sometimes, it can be better to watch the market react to news than to be a part of the reaction.
This may be because of the recency bias, or because the mind makes information recently learned more easily accessible. People may give more weight than appropriate to speculative news simply because it is new and they can recall it immediately. In turn, this reduces the weight given to their own earlier research which may still be accurate, or overlook historical trends. Buying on good news leads to a high purchase point, or selling on bad news leads to a low selling point, when you really want to buy low and sell high.
What one might do to mitigate this behavior – A diversified portfolio can reduce risk so that if something does go awry, the exposure won’t be as devastating. Market dips may present the best buying opportunities, but they’re also the toughest times, emotionally, for making a commitment to an investment.
Not the best reason to withhold action – Endowment bias or The Ikea Effect
The perception of value will not be the same for all prospective buyers. What most don’t consider is that it will not be the same for the asset holders either.
Asset holders may experience endowment bias, or that we overweight the perceived value of assets we own vs. those we are considering buying. The Ikea effect takes this a step further, because it suggests that perceived value can be added to a product or service when the buyer expends additional effort in the creation of the end product. The buyer will like or value the product more because he or she had a hand in its creation, and people tend to fall in love with their own creations, even if the end result is objectively identical. Investors may similarly fall in love with the stocks that they own because they had a hand in selecting them, creating the investment portfolio, and lose some of their objectivity assessing their value as a result.
What one might do to mitigate this behavior – If there is a portfolio plan that guides the investment choices by a set of rules established for the individual based on his or her risk profile, time horizon, and cashflow needs, an annual or quarterly review of the stocks can take place based on the criteria set forth in that plan.
Not the best reason to act – Herd Mentality
Because of confirmation bias, we are more likely to buy into what we see our peers doing or see the market doing as a whole. It’s difficult to be a contrarian, or “to be greedy when others are fearful” as Warren Buffett says. At least when going with what most others are doing, if the investment does poorly, one has plenty of fellow sufferers with whom to commiserate. On the other hand, by using metrics beyond market price, one may determine whether the popular opinions are over or undervalued and adjust accordingly.
What one might do to mitigate this behavior – lean into behaviors that are demonstrated to be successful regardless of what others are doing in the moment, such as investing over the long-term. One way to avoid market timing errors is through dollar cost averaging, where you invest a set dollar amount in the market every month regardless of whether it’s up or down to capture both the bottom and top of the market and average it out.
Not the best reason to withhold action – Sunk Cost Fallacy or Anchoring
We all want to be right, and sometimes we can recognize that we’ve erred but hope that time will fix the problem for us. The decision was made, and we don’t want to decide against ourselves, and change course. Our mind takes a total loss, based on the idea that we’ve already accepted the cost of taking that risk and making the decision. This is known as the sunk cost fallacy.
In investing, an example of this could be the Anchoring bias, where the selling point or buying point is anchored to a point for the investor that isn’t related to the value or potential growth of the company. For many, that may be the purchase price of the stock. The stock was purchased, lost value, and the investor is unwilling to part with it until it comes back to that anchor price point even if the investor has seen a better opportunity to move the assets into. Or that the stock has done so well that capital gain taxes make selling unattractive.
What one might do to mitigate this behavior – one could consider partial sales of an asset in order to make the sell decision more palatable in terms of spreading the capital gains across multiple years or capturing the losses as tax harvesting against other gains.
These are only a few examples of how investor biases can allow emotion to affect their valuations of assets. It’s not wrong to love the stocks or companies you support, or to allow factors other than profit and loss into your investment plan. However, too much emotion can be hazardous to our wealth, and it can be helpful to have an outside advisor taking an objective look as well.
That’s where Garden State Trust Company can come in and provide a second opinion, and help develop a plan based on your unique needs and provide reviews of that plan to course correct and ensure everything is on track. If you’re interested in a consultation, please reach out to let us know.
