This year has been somewhat like a master class, or real-time laboratory, in illustrating some classic concepts of behavioral finance in a compressed time frame.
Think about it.
Investor emotions and behavior have been on a roller-coaster ride throughout 2020—unlike any period I can recall over the past 40 years.
Not only have markets exhibited sustained volatility for months and outsized moves to both sides, but investors have had very real fears over their health and that of family and friends, and almost everyone has seen workplace and daily life disruption (if not loss of a job or a furlough). Add to this societal upheaval across the nation, the prospects of one of the most contentious elections in decades, and entire industry categories facing unprecedented challenges for survival.
How could even the most hardened and experienced investor not have encountered some periods of doubt and uncertainty this year—and been tempted to make some classic investment mistakes?
What investors have experienced this year so far
Charles Schwab Investment Management hosted a webinar in June that had some interesting insights on how behavioral finance concepts came to the forefront in 2020, showing a range of investor emotions and biases that were triggered and how financial advisers and their clients could potentially deal with them.
One of the first charts presented in the webinar simply placed the volatility of 2020 in the context of other financial crisis periods.
A second chart reviewed the last few years and how market-influencing events, and the media’s coverage of them, trigger two different types of investor reaction and biases: cognitive and emotional. Cognitive bias, they said, is when “we think we are being rational and can outsmart the market.” Emotional bias is when the most basic instincts take over, such as the primitive urge of “flight to safety.”
4 investor behaviors seen in 2020
Omar Aguilar, Ph.D. and a senior vice president and CIO at Schwab, pointed out four specific investor behaviors seen in 2020:
- Loss aversion bias: “Reluctance to realize a loss because the emotional jolt of a loss is about twice as powerful as the joy from a gain.”
An example of this in 2020 would be investors who did not sell when the market rapidly fell 10% and went on to see their investments fall an additional 20% or more. Aguilar noted that a flight to U.S. Treasurys, sending yields lower, occurred when sellers of stocks did exit the equity market.
- Recency bias: “Overextrapolation of the recent past or present into the future.”
This has been seen in the rapid decline of the markets during the worst of the pandemic crisis, as well as the continued rally since the market lows. Aguilar said we have seen both sides of the equation this year—people perceived things could only get worse, and then perceived things could only get better.
At the top in February 2020, 11 years into a bull market, many investors likely thought that the rally would go on forever. When the market fell over 20%, many may well have thought a repeat of 2008 was coming, with a decline of over 50% possible. Based on their recollection of that past experience, they scrambled to exit the market.
- Confirmation bias: “The tendency to ignore information contrary to your point of view or interpret all information in a manner favorable to your point of view.”
This was not only seen in investors’ evaluation of the markets, with bulls and bears alike finding data supporting their positions, but also in aspects of everyday life. For example, Aguilar says that early in the crisis “empty shelves and overloaded carts convinced many shoppers that their worst fears were being confirmed.”
- Overconfidence bias: “Overconfidence can lead to overestimating the value of one’s insights, excessive trades, and inappropriate risk taking.”
This behavior, says Aguilar, was particularly noticeable in retail trading trends, where “unprecedented stimulus paved the way for fear to evolve into greed, and trading spiked.”
More examples likely in the coming months
In an upcoming article, he reinforces the notion that 2020 has been rich in real-time behavioral finance observations, and projects that more examples are likely to come. He writes, in part,
“At present, people all over the world are concerned, to put it mildly, about going to work, socializing, visiting their parents, or sending their children to school. Many have no work to go to. Families have been forced into a new normal of constricted behavior. The notion that everyone can turn all of that emotional stress off, sit calmly down at their computers or the kitchen table, and make rational financial decisions is highly suspect. There is little question that the collective anxiety in the population is being reflected in the markets, and the impact of crowd psyche on the markets isn’t always intuitive.
“First, we know that investors will discount both stocks and the market for uncertainty (certainty or ambiguity bias). The initial drop in the market from late February into late March undoubtedly represents the onset of uncertainty surrounding the virus and the closing of businesses around the country. Selling tends to beget selling (herding bias), at least among participants who are overleveraged or simply more temperamental (loss aversion).
“In addition, the markets had been enjoying one of the longest bull markets in history, causing at least some investors to want to lock in those gains quickly at the first signs that trend might be ending (disposition effect). Some degree of panic-based selling (fear of the unknown) finally brings the market down to levels where cash-laden investors perceive a low-risk entry point on the buy side (fear of regret or fear of missing out) and a recovery ensues. From a behavioral perspective, this much at least is somewhat intuitive.”
Lehman sees the environment now as far less “textbook,” but displaying all of the signs of a period of classic “underreaction-overreaction.” Whether it is Federal Reserve policy, progress on vaccines/treatments, continued spikes of the virus, the status of government stimulus and relief policy, corporate earnings, or economic reports, markets are highly dependent on and reactive to the news flow.
He writes, “Each market crash and recovery of the modern era has had its own unique causes and recovery characteristics. Market players are still people first, and, to a large degree, it’s their perceptions, beliefs, and emotions that drive prices.”
Within this context, perhaps more than ever, the discipline of dynamic risk management will benefit financial advisers and their investor clients.
For example, turnkey QFC portfolio solutions from Flexible Plan Investments offer a simple way for investors to get the investment tools they need to traverse today’s markets. These solutions apply dynamic risk management at three different levels (within the funds in the strategies, the strategies in the QFC portfolio, and the QFC turnkey portfolio solution), which results in multiple benefits to investors:
- The confidence that their portfolio is working continuously to smooth out volatility.
- The long-term compounding advantage of helping avoid deep portfolio losses.
- Access to sophisticated risk-management tools in an investment strategy that is customized to their risk tolerance.
I think Peter Mauthe put it well in this space two weeks ago when he discussed Flexible Plan Investments’ ongoing process of strategic development:
“We consider this type of evolutionary change—the continuous development, refinement, and maintenance of our dynamically risk-managed strategies—part of our responsibility to help you navigate the market as it continues to shift and change.”
I don’t think you need an advanced degree in behavioral finance to appreciate Flexible Plan’s commitment to helping investors in meeting their long-term investment objectives.
(Note: Please see the Proactive Advisor Magazine article, “10 destructive behaviors of ‘emotional investors’” for further discussion of many common behavioral finance issues that investors frequently encounter.)
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