One of the reasons investing can be challenging is because humans are quite emotional thinkers. In investing, you need to walk that fine line between using your soft skills and judgement on the one hand, and cold hard facts and discipline on the other. This is often easier than it sounds, and one of the major ways in which investors get this balance wrong is through what is called cognitive biases.
Cognitive biases are subconscious thought processes in our brains that influence our thinking, often without our conscious mind realising it. Think of these biases as ‘rules of thumb’ for your brain. These rules might be useful as a survival instinct, but are often the investors’ Achilles heel if not managed properly or understood.
One such bias which I would like to focus on in this piece is called action bias. Quite often, investors feel the urge to take action, either to buy the latest hot thing in the markets, or to react to a major event or downturn. Taking action makes us feel as though we are in control and as though we are making a positive difference to the situation. The truth, however, is probably quite the opposite! Taking action to change things is all a part of investing, but making rash decisions without following your usual (hopefully comprehensive) investment process is where bad decisions can come from.
As a society, we also tend to view inaction as lazy or not having your eye on the ball. This societal pressure can sometimes persuade investors (both individual and professional alike) into making changes to their portfolios based almost purely on emotion, letting the ‘balance’ noted above, go out of the proverbial window.
The key with these cognitive biases is to understand that they are a part of our psyche. We can’t just switch them off or stop them from happening. The best we can do is to spot when they are driving our thinking and then question our decision-making process accordingly.
In my experience, action bias often comes to the fore when markets are very volatile. In strongly rising markets investors can often get pulled in to the asset class that is performing the strongest (the ‘FOMO market’) and in falling markets, investors can get scared out of the stocks that they (should have) researched well prior to committing capital. One of the best ways I have found to combat action bias is to take a step back and get a longer-term perspective, as I’ll explain below.
Falling markets
Let’s illustrate this point with an example. Let’s say you are investing for the next 20-30 years or more and the markets have fallen by 20% over the last year. What difference will this market fall make to your overall plans? More to the point, what can be achieved by selling in to a falling market? Are you so concerned that share prices will fall significantly in the short term (when you do not need access to capital) that you need to sell now, thereby also removing your ability to benefit from the upswing in prices, whenever it may come?
History cannot tell us the future, but it can be useful as a guide. As Mark Twain said, ‘history doesn’t repeat, but it does rhyme’. Data from JPMorgan indicates that over the last 41 years, the average intra-year decline of the S&P500 has been 14%. That’s just the average, not the worst case. Additionally, 31 of the 41 years have seen positive overall returns in the calendar year. What that means is that a fall of around 14% during the course of the year is completely normal for the S&P500. This can be vital context when occasionally, the world’s financial media may proclaim a ‘stock market crash’ after a 5 or 10 per cent fall in share prices, thereby triggering a sense of urgency in investors.
Rising markets
Rising markets can be just as problematic for our emotionally-vulnerable minds. Sometimes a certain sector, share, or asset class, can capture the market’s imagination and then rises in value significantly over a relatively short time period. Think technology shares in the late 1990’s, banking shares in the early 2000’s, Bitcoin/Cryptocurrencies in 2020 – there are countless examples.
The danger here is that investors get sucked in to buying the ‘flavour of the month’ asset purely because everyone else is. There is a 'fear of missing out' at play. ‘Other people are making money, so why can’t I? ‘ – kind of logic. I’d argue that this is action bias at play. Investors feel that they need to take action to get exposure to the latest thing in the markets. There's a great quote from fund manager Peter Lynch that sums this up, as follows:
When these asset bubbles burst, they can be quite painful. I’ve said many times before but i’ll say it again. Whatever you invest in, you should believe in. If you don’t believe in your investments and understand them fully, don’t make the trade -regardless of the rest of the market.
I hope this article can help you with your own thinking or indeed that of those you entrust to manage wealth on your behalf.
All the best,
Louis
The views expressed in this article are my own.
This information does not constitute advice or a personal recommendation
Source: JPMorgan Guide to the Markets, Q1 2021
Comments