Behavioral finance explains why investors tend to react emotionally instead of rationally. There are dozens of emotional biases that may apply to investing. Let’s talk about a few of the more common ones that may come into play during or after a market downturn.
1. Recency bias
Recency bias relates to our ability to recall information obtained recently more easily than information we received further in the past.
The 11-year bull market in U.S. stocks that started after the Global Financial Crisis receded is a perfect example of this. Over the last decade-plus, most investors became accustomed to seeing nothing but gains in their investment accounts; so much so that many investors simply forgot the pain of 2007 and 2008. Some even believed it would go on for even longer.
This, of course, is not (and never will be) the case. In March 2020, markets across the globe were in a freefall due to the COVID-19 pandemic and trouble in the oil patch, bringing the bull market to a screeching halt. But remember: just like the good times, the bad times don’t last forever (as we saw when the market rebounded in the rest of 2020).
2. Herd instinct
At some point in your life, you may have heard—or perhaps even posed—the question: “if everyone else jumped off a bridge, would you?” (I know I’ve been on both sides of that query!)
Well, the truth is that when it comes to investing, many investors might say “yes” to that question. It’s tempting to base investment decisions—either buying or selling—on what everyone else is doing, rather than performing your own research and analysis.
Herd instinct is a result of the human tendency towards FOMO (or fear of missing out).
3. Loss aversion
Research from preeminent behavioral finance experts Daniel Kahneman and Amos Tversky shows that investors tend to feel the pain of financial loss far more intensely than they feel the pleasure of financial gain of the same size.
Investors who have lived through painful market crashes may become fearful of further losses. This can lead to inappropriate and overly-conservative investment decisions—such as pulling all money out of the market and into a savings account.
Sure, money in an FDIC-insured bank account is safe; but it’s still not totally risk-free. Inflation risk—or the risk of the returns you earn from a savings account not keeping up with the rate of inflation—is a very real possibility.
So, what’s the best way to avoid behavioral biases during tough markets?
Working with a third party expert is a great idea. An experienced financial advisor can help you keep your emotions in check, and prevent you from making decisions out of panic or fear. Click here to make a free, no-obligation appointment with one of our advisors.
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