I once heard, “Your mind is like a dark alley, it’s not somewhere you want to be alone for very long.” The COVID-19 virus has introduced shelter-in-place orders and social distancing measures that have separated us from family members, friends and the places that we love. If there was ever a time for our minds to play tricks on us, it’s now.
Today, more than ever, investors are at risk of making emotional financial decisions. COVID-19 has had major impacts on the stock market, employment levels, the healthcare industry and pretty much every facet of our individual lives. Most investors have faced market corrections before. In fact, there’s been an average of one market correction per year since 1928. For most folks, health concerns aren’t uncommon. And the pangs of loneliness have impacted pretty much everyone at one time or another. What we haven’t necessarily dealt with before though, is handling the impacts of all three of these stressors at once.
In times of crisis, it’s easy to feel a loss of control. For many people, that leads to a desire to take action – any action – to feel like they’re doing something. One of the many problems with emotional decision-making though, is that it can lead you to make choices based on short-term circumstances. Those decisions are often very reliant on cognitive biases, or filters through which we view events, that can end up clouding your judgment.
In my experience working with clients for more than two decades, I noticed four cognitive biases that can derail financial plans:
- The tendency to think that examples that come readily to one’s mind are more prevalent and relevant than they actually are, is the hallmark of availability bias. Have you ever bought a new car and suddenly you notice the same make and model everywhere? That’s availability bias at work. The actual amount of those vehicles on the road did not change, but your awareness did because you now own one. In investing, availability bias could take the form of selecting investments based on a company’s frequent advertisements, rather than by reviewing their process and track record. The advertisements have seeped into your subconscious, convincing you that because you can remember the company’s name easily, it must be better than other alternatives.
- Put simply, negativity bias is having a stronger intensity of feeling when it comes to negative emotions than you do about positive ones. Negativity bias is the reason that you see so many disparaging political ads on tv. Those politicians discovered long ago that it’s much easier to generate strong, negative feelings about their opponents than it would be to create positive feelings about themselves. In investing, negativity bias can feel like the risk of loss outweighs the potential gain, even if the mathematical probability of a negative investment result is significantly smaller than the probability of a gain. Negativity bias is also often referred to as “loss aversion,” where the fear of losing money drives people to make changes to their retirement plans, when they would have had greater statistical odds of success had they just “stayed the course.”
- Confirmation bias is the tendency to subconsciously pay more attention and give more weight to information that supports feelings that we already have. It’s the factor at play when you see the silver lining in any situation on a great day, but nothing but clouds when your day’s been bad. Confirmation bias is particularly dangerous when investors are scared. During those times, it subtly pokes at investors’ minds, encouraging them to lend weight to information that accelerates a scared feeling, while dismissing any information that could give them comfort.
- Recency bias happens when a person places a higher value on recent situations than on those that have happened in the past. Recency bias is something that you have to be careful of regardless of market conditions, because as my business partner says, “It’s never as good as it seems or as bad as it seems.” Recency bias is also the principle behind legendary investor Warren Buffett’s philosophy of being “fearful when others are greedy and greedy when others are fearful.” Buffet knows that everyone is susceptible to recency bias and he uses it to his advantage.
All four cognitive biases can have dramatic impacts on an investor’s financial future. They’re often the main reason why “staying the course” can be such a difficult task. A recent Bank of America study drove home the impact that patience and a long-term mindset can have on your end result. The study found that if a person invested in the equity market in 1930 and simply stayed put, their returns would have been 15,000 percent. If that same person instead decided to make changes to their investment account, which then caused them to miss the top 10 performing days of each decade, their returns would be just 91 percent. The lesson is clear- letting emotions or cognitive biases drive your investment behavior, could end up costing you lots of potential returns.
During difficult times, it’s common to feel like you need to do something to actively monitor and better your situation. The best way to combat the effects of cognitive biases though, is to step away from the metaphorical “controls” and instead lean in to the overall financial plan and disciplined investment strategy developed by your financial advisor.
If sitting on your hands isn’t your cup of tea, here are a few things that you can do to ease your discomfort, while not altering your overall plan:
- Rebalance your portfolio. If you began the year with a target asset allocation, your current portfolio composition is likely very different from your original. Rebalancing now would keep you aligned with your initial goals, while also helping you to adapt to the current environment.
- Harvest losses in your taxable accounts. Selling stocks that have a current loss would allow you to recognize those losses on your tax return. In order to maintain your overall allocation, you could reinvest in companies that are similar to your original holdings.
- Make contributions to your investments if possible. Historically speaking, the current downturn represents a buying opportunity. If you have available capital, you could put some of it to work.
- Buy or sell partial positions. There’s no rule that you have to sell all of your shares in a given company, nor do you have to buy as many shares as you can at any given time. You can dollar-cost average into your investments over time.
It’s easy to be concerned about whether or not COVID-19 will impact your retirement. If you have a financial plan that was developed before the crisis and your goals haven’t changed, then your plan shouldn’t change either. By being aware of the four cognitive biases when making financial decisions, you can make a tremendous difference in your outcome. Rather than reacting in fear to the current environment, you can create an action plan to respond with small steps that will allow you to continue moving toward your ideal retirement.