Your Emotional Biases Can Hurt You Financially. So Can the Emotional Biases of Others: Four Mistakes You Can Avoid
Our relationships with wealth and investing? Chances are they’re complicated and sometimes emotional. Our financial planning, really our financial planning discipline, is regularly affected by emotional bias.
It’s challenging to be rational all the time in how we make financial choices. In retirement planning and investing, emotional bias can do permanent damage and destroy wealth. Financial planning can suffer.
Common emotions that influence how we spend and invest include:
In terms of investments and financial planning, these and other emotions could lead to decisions that adversely impact your portfolio in the long run. For example, the impulse to “follow the crowd” due to fear of missing out or to sell shares impulsively when stocks start trending down can destroy wealth permanently. Or people may badly harm their retirement planning, a process built to last decades, by reducing their equity allocations in response to a tumbling stock market. Insufficient allocations to long-term growth can be a disaster for retirement planning because it risks running out of money.
When it comes to keeping money through financial planning and tax planning, and also growing money through good allocation of capital and wealth management, some of the biggest mistakes are created not just by overconfidence spurred by optimism, but by several kinds of psychological behaviors and natural but erroneous shortcuts taken by the human brain.
Here, there is good news and bad news. The good news is that research has taught us a lot about how and why people make these mistakes. That is, research has improved our understanding of these mistakes and really has made them unnecessary mistakes.
The bad news is that these risks exist and if left unmanaged, can do damage to otherwise sound financial planning.
Consider these three emotional biases, totally within your power to control, plus one area where your financial planning can fall victim to the biases of others.
1. Overreaction to What Really Is a Short-Term Event:
For example, you may hear that a CEO of a major corporation is stepping down because of a fraud allegation against him. In turn, your first reaction may be to get rid of your stock in that company. In reality, his stepping down may not have any impact on the company’s performance – especially in the long run. Imagine that instead of thinking about that company’s value over the span of years or decades, you made an in-the-moment decision based on short-term changes. Your gut reaction was to protect your assets right now, when in reality, you may have actually hurt your chances for successful wealth management over the long run.
Research has shown that the more often people look at how the market is doing, the more often they trade, and the more often they trade, the more mistakes they make. Disciplined capital allocation to the stocks of superior companies is critical. Sticking with these investments for the long term is also important because strong companies retain their earnings and direct that retained cash to high-ROI activities.
2. Recency Bias:
Recency bias is another brain-created trick which can cause unnecessary and costly mistakes, especially for business owners. Recency bias means that human beings tend to project recent events into the future indefinitely. In other words, people make the mistake of thinking that what has been happening recently will continue to keep happening. For example, Bloomberg surveys of market strategists showed the highest stock allocation recommendations occurred in early 2001, when markets were at their high point. It’s the opposite of buying low. Similarly, at or near the depth of the market crisis in 2008 and early 2009, many strategists were recommending reducing stock holdings. If buying low and selling high is the obvious strategy, why were some of the supposedly top financial advisors in the world telling their clients to do the opposite? Part of the explanation is recency bias.
3. Herding Bias:
Recency bias frequently travels with its friend, herding bias. Herding bias is an impulse to follow your peers whether the crowd is euphoric or consumed by panic. Whichever extreme, recency and herding make us abandon independent judgement.
It's possible to build plans and strategies that are fortified against both recency and herding. By design, these plans are organized to be passive most of the time, especially during periods of volatility. Good planning and advising means innovating in the beginning and then staying the course.
4. Overvaluation: When the Biases of Others Can Hurt You
Even if you are personally quite adept at avoiding emotional biases in financial planning and wealth management, you can still be harmed by the biases of others. This is particularly true if you utilize a passive investing strategy.
Passive investing uses low-cost index funds – either mutual funds or exchange-traded funds, or ETFs. It puts a lot of wealth management on autopilot, which eliminates many situations where you otherwise might act emotionally. Palmerston generally favors an active approach to investing and wealth management, but we also recognize that passive strategies have a lot going for them.
Except when the emotional biases of others become embedded in markets, such as when speculative overvaluation creates sector bubbles. Much of passive investing is tied to the S&P 500 Index. When particular sector bubbles deflate, they take the whole S&P index down with them.
When the tech bubble burst in 2000, the market caps attributed to technology stocks re-priced downward and made the S&P 500 a whole lot less valuable. It took nearly seven years until the S&P, in 2007, regained its previous high. It took years to regain those losses because the real value of companies needed to grow and make up for the losses created when the speculative overvaluations of many tech companies collided with reality.
A similar story occurred when the market imposed its discipline on the overextended financial sector in 2008 and 2009. Once again, a bubble in part of the S&P 500 index clobbered the value of the index as a whole. Passive investors expect index funds to play the field. They expect an index to lower risk through diversification. And while index funds often do that, they fail to lessen risk if markets are unreasonably bidding up portions or sectors of those indexes.
What might be some financial planning alternatives for people who like the idea of passive investing but who want to mitigate the risk of sector bubbles destroying long-term value?
One approach that we think is worth exploring is to create a basket of passive investments. There’s a world of mutual funds and ETFs which track many different slices of the economy: indexes tracking small and mid-cap companies, indexes by country and geography, indexes based on industries. Looking smaller can reduce the risk that speculation in one overvalued area of the market will negatively impact a passively-based portfolio.
A second financial planning approach is to consider an active approach, but one that aims to identify high-quality investments that can be held for a long time. Great companies tend to be great allocators of capital. They tend to retain and reinvest their earnings effectively. And one can blend in some select indexes as well. When an actively managed portfolio is composed of many positions which you plan to hold for a long time, you should be able to achieve much of the balance and diversification that index funds are supposed to provide but sometimes don’t. And it may be a way to reduce the risk of overvalued sectors, bid up by the emotional bias and euphoria of others, bias that is a threat to your long-term financial well-being.
Interested in a free assessment? Please click here.