How to Counteract Behavioral Biases That May Hinder Your Investment Success
By Dan Duca, CFP®, Associate Director, and David Kressner, CFA, CFP®, Managing Advisor
Altfest Personal Wealth Management
One of the key elements of our work as senior advisors at a comprehensive financial planning and investment management firm is to guide our clients toward the soundest decisions possible for their finances. Our goal is to help them achieve their financial goals in a way that’s comfortable for them.
But often, behavioral factors you may never have thought about, such as recency bias, loss aversion, and procrastination, sometimes known as status quo bias, prove to be some of the biggest obstacles we face in assisting clients. Let’s briefly discuss these very common errors in judgment that we see, and then review some ways to avoid them to stay on a productive path with your portfolio.
There’s an emerging field of study regarding behavioral factors in investing. This work is considered so impactful and important that pioneers in this area of study have actually won the Nobel Prize for their research. One of them, Prof. Daniel Kahneman, has said, “Economists think about what people ought to do. Psychologists watch what they actually do.” Kahneman is largely credited for enlightening psychological research on how we, as humans, make decisions about our money and other critical life choices in the face of uncertainty.
Take a minute to think about whether you’ve exhibited any of these behaviors when managing your finances.
Recency bias occurs when you assume what’s happened recently will happen again soon or will continue to happen. Two examples of this behavior we’ve encountered with clients in the not-too-distant past come to mind. One was in 2021, when technology stocks lifted the market and investors piled in, thinking that trend would continue. In our opinion, it fueled speculation: We already were seeing stock prices grow increasingly disconnected with their fundamentals.
The other example came just last year when we saw nearly the opposite. Almost all major financial markets fell significantly and left investors worried and turning away from stocks; they convinced themselves the bad performance that happened recently would continue and they were afraid of further declines.
In that case, giving in to recency bias and running for the proverbial exits is tempting but unlikely to yield good results. A better approach is keeping a long-term perspective and sticking with your strategic allocation. That might look quite different for each investor. What’s important is that it be aligned with your long-term goals and, perhaps more importantly, with your risk tolerance. Establishing this type of thoughtful strategic allocation is something that we work with most clients on at Altfest Personal Wealth Management.
In addition to setting up a strategic allocation, having the discipline and sometimes the courage to stick with it is critical for long-term investment success. In our experience, clients tend to overestimate their appetite for risk when times are good and underestimate their risk tolerance during turbulent times, perhaps like now, having come off a very challenging 2022. The takeaway: It’s very important to have an honest handle on your own risk tolerance, because changing your mind can be costly.
Loss aversion is the behavioral bias that suggests people experience more pain from loss than they experience pleasure from gain. In fact, it’s been quantified, and perceived pain of loss has about twice as much weight as does enjoyment of gain. Due to this aversion, investors are tempted to try to time the market, go completely to cash or to sometimes adopt an overly conservative portfolio allocation.
The chart below illustrates the potential damage that loss aversion can do by showing the hypothetical impact of being out of the stock market for a certain number of days. The tallest bar on the left shows that if you invested $10,000 in the S&P 500 20 years ago, that has grown to nearly $65,000 today, a substantial return. The next bar, though, shows what the impact would be if you missed only the 10 best days — your investment value would be cut in half. Keep in mind, there were roughly 5,000 trading days over this 20-year period, and we’re talking about only missing the best 10.
It’s hard to believe there’s such a dramatic difference. And what if you’d missed the best 30 days? Looking at the bar in the middle, you can see that nearly all the stock market appreciation over the last 20 years is lost.
It sounds understandable to want to pull out of the market when things look grim or perhaps at the first signs of a decline, wait on the sidelines, then get back in when things appear calm.
In reality, though, the worst market days often happen very close to the best days during periods of extreme volatility. Whether you’re a professional investor or not, avoiding short-term losses is extremely difficult, and attempting to do so could instead do damage to your portfolio.
So, what are we supposed to do? Investors wrestling with loss-aversion bias often feel as if they need to do something to take control. And as discussed, trying to time the market is not a prudent strategy because short-term losses tend to be erratic and outside investors’ control. So why not focus on things we can control?
Many of our clients moving into retirement may be drawing more from their portfolio, so they guess that they should abandon the investment strategy that they had in place for years and pivot to focus exclusively on income and principal protection in their portfolio. But in reality, for people entering retirement today, the time horizon usually remains very long, possibly several decades. So rather than worry about temporary market losses, the far more-damaging factor for most retirement plans is persistent inflation, which erodes the value of clients’ assets over time in a much more insidious but predictable way.
Inflation is grabbing a lot of headlines now because it’s been running at such a high level. But even at more modest levels such as 3%, the impact over time is dramatic. So, when we work with our clients, we’re trying to help them understand these dynamics and really fight that urge to avoid loss that may not serve them well. To combat the long-term pressure of inflation, we recommend pushing back against the desire for loss aversion, and maintaining a diversified portfolio that includes growth investments, even in retirement. They may be subject to temporary declines, but we think that the growth that they can provide should offset inflation and more than make up for the risk of short-term losses.
Status Quo Bias
Last, the status quo bias behavioral factor is commonly defined by procrastination and inertia. It’s the preference to maintain an existing arrangement, to stick with the status quo, if you will. Another side of the same coin can be the preference against taking any action that will change the current state of affairs.
But truthfully, people’s needs change over time, and your portfolio and full comprehensive financial plan need to be reviewed regularly to acknowledge this. So, while we favor a long-term perspective for investing, that doesn’t mean that you should put your head in the sand and do nothing. It’s important to reposition your portfolio over time based on the prevailing opportunities in the market. With our clients’ portfolios, we use a disciplined but active approach that focuses on the fundamentals and valuations.
Let’s consider life insurance specifically when thinking about status quo bias or inertia. Maybe you first purchased life insurance early in your career, perhaps you had a large mortgage with a remaining term of 20 or 30 years, maybe you had young children for whom you wanted to provide a college education, maybe your spouse or partner worked at home or didn’t make as much money as you did and you wanted to make sure there was money available if something were to happen to you.
Now, fast-forward to today. You’ve paid down most of that mortgage, maybe you’ve saved for your children’s education in tax-advantaged 529 plans, possibly you’ve saved a considerable amount of money for your nest egg since then. All these updates likely point to needing less coverage than you did when you first purchased your insurance. As we can see here, it’s critical to revisit financial planning when appropriate and not let procrastination and inertia get the better of us.
Find Out More
At Altfest, we’re always ready to help you find the best ways to recognize and counteract behavioral factors that may be affecting your financial future. We know each client or potential client’s situation is unique, so reach out to our firm with any financial planning questions we can address. Altfest advisors are prepared to evaluate your circumstances and offer ways to avoid common errors in judgment so that you can maximize the potential of your portfolio.
If you’re not yet an Altfest client, please book some time for a complimentary consultation.