Why do so many investors make decisions based upon emotional reactions to short-term events? Because we’re human. Greek debt troubles, Chinese stock market declines…it’s normal to feel anxiety during economic downturns or market turmoil, but acting upon those anxieties can lead to poor investment decisions. The key is finding the balance between emotion and reason.
Research in behavioral finance deals with cognitive errors or biases that all of us tend to make, especially in times of stress. One of these errors — confirmation bias — represents our tendency to look for information that support our beliefs. If we believe the market is going to decline, we seek pessimistic evidence. If we think markets have nowhere to go but up, we chase after optimistic data—and tend to discount anything that suggests other possibilities.
Confirmation bias can also extend to our beliefs in our own abilities as investors. As Meir Statman, Glenn Klimek Professor of Finance at Santa Clara University, says: “Investors who believe that they can pick winning stocks are regularly oblivious to their losing record, recording wins as evidence confirming their stock-picking skills but neglecting to record losses as disconfirming evidence.”
If you think you’re immune, you might want to read this recent article in the New York Times, which includes a simple confirmation bias quiz.
When the markets are unsteady, investing requires discipline and patience in order to overcome our emotional tendencies. It’s tough to stand firm when the herd is chasing after the latest hot fad or stampeding in panic. The more we understand how our emotions can get in the way of making wise decisions, the more likely we are to be able to balance those emotions with reason.
Stuffing cash in your mattress, for instance, may seem prudent to some, but you’re out of luck if your house burns to the ground.
Achieving your long-term financial goals means accepting the trade-off between risk and return of different investment asset classes, and combining those asset classes to manage risk through diversification.
This kind of approach isn’t flashy, and it’s not always popular in some quarters, but we believe it can offer investors the highest probability of achieving their long-term goals…as long as they don’t let emotions and biases get in the way.
To learn more about emotions and investing, check out these past blogs on the Gambler’s Fallacy and the Hot Hand Fallacy.
