Recognizing the top three behavioral biases
Participating in the equity market can often trigger numerous emotions for many investors. Those emotions can range from mild fear, to excitement, to euphoria, or to downright panic. Our reactions to such emotions are often muted during bull markets and likely amplified during bear markets. Although deep down we all truly understand the importance of avoiding our emotions when investing, such a task becomes difficult during times of volatility.
Emotions also tend to introduce behavioral biases in the way we decipher and interpret new and existing information. We believe such biases are often most detrimental during periods of increased volatility as they could incorrectly guide investors’ desire for equity market participation. By recognizing the top three behavioral biases and acknowledging their potential impact in the way decisions are made, investors may be better positioned within their long-term investment strategy.
Anchoring bias refers to the idea that investors sometimes fail to look beyond the current set of news that they have been exposed to. As a result, we’re anchoring our conclusions, and decision making, only on an initial piece of information, irrespective of how positive or negative it may be. This can often lead to misguided decision making due to the unwillingness to further expand our information data set. An anchoring bias may be most prevalent for those investors that have emotional connections to specific stocks. It can also be evident during times of economic contractions when the availability of pessimistic news tends to exceed those headlines attempting to pinpoint positive data.
Once investors fall victim to the anchoring bias on an initial set of information, many are subject to confirmation bias. Such a bias can result in the tendency to search, or interpret, new information in a way that confirms and strengthens one’s initial view. In other words, we purposely avoid the opposing point of view and neglect to place much emphasis on arguments that significantly differ from our own. We believe confirmation bias can be the most detrimental in a bear market. The reason for that is because bad news is often easier to acquire when we’re in a bear market. If we fail to analyze information that has the potential for market upside, an investor may be left behind.
Hindsight bias occurs when we place too much emphasis on historical relationships as a means of gauging what may happen in the future. Although historical analysis may often produce actionable insight, it becomes imperative to account for the inherent differences in the current environment relative to the economic and market environment of our comparison. The two are rarely identical.
Edison Byzyka, CFA – Chief Investment Officer – Credent Wealth Management
Investment advice offered through CX Institutional, a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted.
All other data, including returns, soured from Bloomberg, through the release of monthly figures from the Department of Labor, Bureau of Economic/Labor Statistics, U.S. Census Bureau, or from the Federal Reserve and any of its affiliated regional locations.
Small Business Optimism sourced through NFIB. Small business hiring plans sourced through NFIB. Consumer sentiment sourced through the University of Michigan.
Earnings data sourced through Bloomberg Intelligence and through Bloomberg’ earnings analysis composites. Interest rate cut/rise probabilities are sourced from Bloomberg’s tracking of futures contracts tied to the Federal Funds interest rate.
Economic Policy Uncertainty data sourced from Bloomberg via The Baker, Bloom, and Davis Index.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changed in the aggregate market value of 500 stocks representing all major industries.