How Biases Can Impact Investors’ Financial Well-Being and Significantly Alter Accumulated Wealth, Part I
Undoubtedly, 2020 will go down in history as a record setting year, but also as one of, if not the most, hated and devastating year in modern time. The worldwide pandemic was an event like the globe had never seen before, bringing with it the shortest bear market ever recorded in history (approximately four weeks), record-level single trading sessions’ declines, record-level single trading sessions’ surges, and one of the fastest recoveries on record, all within few months.
While many of us celebrated the end of 2020, and as most individuals are optimistic about what 2021 brings with the development and administration of the COVID-19 vaccine and the potential of getting back to normal, some investors were skeptical because of the Democratic sweep after Georgia’s senate elections. Some anticipated a major market decline, while some optimists predicted a market correction (a drop of 10% or more in market index). Keep in mind, corrections are typical and can occur a few times in any given year. As always, the market keeps us all humbled and to the contrary of these predictions, in the past few weeks all major U.S. indices hit record highs. This is not surprising, however, as it actually reminds me of the panic after the 2016 elections.
Nevertheless, market fluctuations in both directions, coupled with fearful events such as the COVID-19 pandemic and election results, tests investors’ nerves, cause confusion, and are likely to cause some investors to act irrationally. Why would anyone act irrationally when making financial decisions? These important decisions should always be guided by solid financial principal, correct?
The answer is not that simple, however, and it requires a little more digging to understand how the decision-making process works. However, the short answer to satisfy your curiosity is, either our logic is flawed, due to one or more incorrect perceptions or we use our emotions to make these decisions. In either case, our behavior was simply “biased”. When we, subconsciously, allow these biases to control our behaviors when making financial decisions, we act irrationally.
Through this series, I’ll attempt to expose some of the major, and most common, biases most investors experience to help them avoid making costly mistakes, not only in periods of market stress and uncertainty, but also in periods of market growth.
Earlier, I asked whether investors use their minds or hearts in making investment decisions. Chances are, most people will choose the most logical answer and quickly claim they use their minds, because it’s the most rational choice of the two. Well, let me tell you that even if you think using your brain will always yield the most rational outcome, you are mistaken. This is because your brain would probably reach different outcomes under other circumstances, even under different presentation methods of the same circumstances. Additionally, depending on the behavioral “investor type” you resemble, which we will cover later, your very own action would differ.
Although studying the decision-making process under uncertainty has been examined by many researchers and scholars since the mid 1950’s, “behavioral finance” is a topic that started to develop and take shape in the late 1960’s and it attempts to explain the psychology behind financial decision making. In particular, a 1979 publication by two cognitive psychologists, Amos Tversky and Daniel Kahneman, produced the Prospect Theory which will later become the cornerstone in studying how people make decisions under uncertainty. The Prospect Theory concluded that individuals tend to feel the impact of losses two times more than the joy of gains. This asymmetrical outcome suggests that most individuals, by default, are risk averse. This conclusion forms a critical foundation for much of the behavioral finance theory.
Let’s take a step back to ask an important question: “How are our brains trained to function when trying to reach a decision or a conclusion?”
Our brains make decisions based on many of the perceptions that we build and accumulate over our lifetime. These perceptions are normally context dependent, meaning these perceptions could’ve been completely different if the context of the situation had been different. Thus, these perceptions are not necessarily the complete and full truth (in other words, not all possible outcomes) but rather an interpretation of particular circumstances, perhaps stemming from experience with a previous set of events. Therefore, when we make decisions based on one or few possible outcomes, we are acting in a biased manner. What are these biases? More importantly, what drives them?
Next month, we’ll dive further into answering these questions regarding biases and how they impact our decision-making, particularly when it comes to our investments. Understanding our biases can help us better understand why we make the financial and investment decisions that we do.
To read the second part in the series, please click here.
If you have a question about this article or are interested in learning more about how First Bank Wealth Management solutions can help manage your wealth, please contact First Bank Wealth Management or click here to contact us.
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