Let's face it. Investing is difficult, and being human makes it harder. That's why even the smartest people are affected by cognitive biases, especially when it comes to investing.
Since Inauguration Day, it's fair to say that many people are experiencing a volatile and highly emotional environment . Whether you're happy with the Trump administration, upset or simply distracted by the widespread protests, raucous Cabinet confirmations, Twitter controversies and reports of spats with foreign governments, investors need to be aware of their biases and the impact they could have on their current investing decisions.
Amidst all of this commotion, financial markets have actually started the year strong. What accounts for the difference between the "chaos reigns" narrative in the media and the relatively calm march higher in financial markets?
One critical point to understand is that financial markets and the global economy are generally far more resilient than our perceptions tend to give them credit for. Over the past century, we've experienced world wars, recessions, depressions, financial crises and more recent international upsets, such as the Brexit referendum — which roiled global markets — and the largely unexpected Trump victory.
Although there's been a lot of volatility and reasons to panic, financial markets are now closing near all-time highs. The collective optimism and ethic that compels people to work hard, innovate, collaborate and prosper continues to drive the economy forward. Nonetheless, it is only human to have emotional reactions to portfolio volatility, whether it be fear and anxiety to losses, or confidence and elation to gains .
Our decision-making processes employ emotional filters to process inputs from situational dynamics, and probability estimates to assess and predict outcomes. In short, we use our emotions as "shortcuts" to trim time from analysis and to make ourselves more comfortable — a process that has major pitfalls. Our individual "intrapsychic systems" — our patterns of thoughts and beliefs based on life experiences, current moods, personal affects and biases — are filters that profoundly alter the outcomes of our decisions. To seek to maximize wealth accumulation over our own life cycles and (especially) across generations, it is critical to seek an understanding of our intrapsychic systems, solve for them and manage them over time.
Our biases, and those of investment managers, programmers and business executives, will come into play even if we hand our money over to advisors or choose "set it and forget it" investment models. Traditional finance offers a wealth of intellectual property—ideas, theories, disciplines, frameworks and logic — that dictate how we should behave in order to maximize wealth over time, but they account for only half the equation.
Traditional finance assumes that cognitive biases play no role in the decision-making processes of human beings, as though we are zombies — apathetic about the most important decisions in our lives. But today's smart advisor understands that human beings are complex, emotional creatures who are actively engaged in their own financial management beyond status reports, right down to decision-making.
Everyone falls into a behavioral finance category. What's yours? Self-awareness leads to positive results. The book "Behavioral Finance and Wealth Management" by Michael M. Pompian details the most common human investor types and associated personal finance-related biases. Can you identify yours?
Type: The Preserver. A passive investor type, Preservers tend to value financial security and wealth preservation far more than growth. They are generally highly risk-averse, and losses are much more painful to bear than gains are a joy to experience.
Bias: Loss aversion. Preservers tend to experience a lesser degree of satisfaction toward gains and a greater degree of dissatisfaction toward losses, even if the amounts gained and lost are equivalent. Research shows that people will more often choose to sell their winners and hold their losers, hoping they can recoup the investment over time, even though this may lead to more losses.
Strategy: Slow and steady. Because volatility causes emotional anxiety, Preservers should not invest aggressively regardless of age and time horizon because they might be unable to stick to their investment plans during periods of market volatility, a tendency that often leads to long-term losses. Preservers should employ less risky, slower growing investments and other methods, such as higher savings, to achieve their long-term goals.
Type: The Follower. A passive investor type, Followers tend to be compliant in taking the advice they receive even from friends, family and colleagues. They are often thoughtful and listen carefully to the advice of others but can be prone to making abrupt investment decisions at the urging of trusted friends or media commentators.
Bias: Regret. Followers fear regret and may undergo stressful emotional processes when threatened with the idea that they may make a wrong or unfavorable choice. People may fear shame or embarrassment and as a result make poor choices. After all, no one likes to be wrong. The result is that no choice is made and a desirable outcome may be missed.
Strategy: Stay the course. Followers should always consider whether or not advised changes are in line with their long-term goals and aspirations, and try to refrain from making snap decisions that dramatically shift the long-term expected risk and returns of their portfolios.
Independents and accumulators
Type: The Independent. An active investor type, Independents can act quickly and decisively, and are usually confident in their own research. Though investors should always take the time to understand their investments, Independents study more than most. They are avid consumers of information and appreciate data over emotion when making decisions.
Bias: Conservatism. Like all active traders, Independents may become overconfident in their own research, and often make major decisions based on a positive or negative market outlook that can put their long-term goals in jeopardy. Independents may hesitate to take action based on new information in favor of initial data or impressions. This leads to inflexibility when it may be needed to attain the most favorable outcome.
Strategy: Match the market. Independents are generally analytical, and like to discuss their investments and holdings with their advisors. Work with a firm that values providing education and metrics to its clients and spend extra time discussing information in the context of specific personal biases to understand behaviors that might undermine sound decision making. Even with extensive data, the best strategy is to invest in the long-term growth of the market, avoiding the tendency to try time it, while remaining agile to reduce risk and capitalize on opportunities where possible.
Type: The Accumulator. An active investor type, Accumulators are risk-takers and have a strong conviction in their ability to be successful investors. They often had great success in business, and passionately believe that they can carry that success into investing.
Bias: Overconfidence. The main mistake Accumulators make is that they often have a false sense of control, and are prone to taking excessive and unnecessary risks in their investments. Accumulators often struggle to adhere to a consistent strategy over the long-term, and may make dramatic short-term allocation changes based on their own beliefs in market direction.
Accumulators can overestimate their own skills and abilities relative to others. As a result, they may believe they can effectively time the market even in spite of an overwhelming body of evidence that proves this is not possible. This results in excess trading costs and associated fees with lower performance over time.
Strategy: Look for blind spots. Accumulators are generally highly confident in their own abilities and may self-select data to reinforce their individual schemes for how they view situations. Accumulators should seek out data that may be contrary to their preconceived beliefs in order to ensure they are achieving a balanced analysis before making important investment decisions.
The bottom line is to trust yourself — and your advisor. Many financial advisors don't consider their clients' (or their own) behavioral biases, because they haven't studied this emerging financial frontier or because they operate under a business model in which investment volume stifles quality. Before you hand over the balance sheet, ask yourself: Do you trust your advisor? Can your advisor provide an objective lens to help you manage your emotions and keep them from costing you money? You should answer with a resounding "yes."
An effective advisor group will offer a differentiated behavioral aspect within its service model, which drives individual wealth accumulation by combining traditional finance and applied behavioral finance. Decision-making is not entirely computerized in its predictability, because emotions play a significant role at every level — but these emotional biases can be examined, categorized and applied predictably when considered.
To leave behavioral finance out altogether ignores a substantiated, significant body of knowledge around the very subjects we serve — human beings.
— By Robert L. Meyer, CEO/Chief Investment Officer at Ibis Capital
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