Unconscious Missteps during Market Volatility & Behavioral Finance

I recently got a media request for WSJ interview about common client misstep during market volatility. When I was trying to think about the common missteps, I noticed that many of them are associated with behavioral finance. While it is hard for retail investors precisely time the market or predict what news are going to come out tomorrow, we can avoid pitfalls that are triggered by emotions in disguise of logic reasoning.

Below I have given some examples of behaviors that I have seen during the recent market volatility that fall under by behavioral finance concepts, and I also share some ways that I found useful in overcoming those behaviors.

Confirmation Bias

I have seen many investors searching for clues in waves of news on tariff, market, treasury bond, individual stocks, etc., but I do find that some clients unconsciously pick up a lot more news that support their existing believes about what’s going to happen with the market. This is confirmation bias, and it happens because you like to read what you believe in, you understand and interpret them better, and therefore you also remember them better. Especially nowadays, many are getting their information from social media, and with the imbedded recommendation system, you are more likely be exposed to information that you read often making it even more difficult that you are subject to confirmation bias.

The way to overcome confirmation bias in my view is to consciously look for points of views that does not support what you believe in and try to understand their reasonings. Just as when I work with my financial planning clients, I always provide a couple of scenarios with different assumptions, that is not because I don’t think the assumptions my client provided is not correct, but instead, it is for us to obtain objective views of what else could happen.

Experiential Bias

During this market volatility, I have several clients telling me that they want to start investing their cash when the market is down XX%, and believe it or not, there are two very popular numbers in our conversations, 25% and 50%. When I dive deeper into the conversation trying to find out where those number come from, it’s usually first describe as gut feeling and then the conversation steered toward their experiences either during “Black Monday” in 1987 (market fell 23%) or 2008 financial crisis (market dropped 54%) – now we know where the popular 25% and 50% came from – outcomes of historical events (seems to be depending on their age if they find 08 financial crisis or 1987 Black Monday more memorable) are used to make current financial decision. However, there are many differences in the economic factors and market mechanisms between now and then, and there is no solid evidence that the market is going to move in the same pattern as former market downturns – it’s more because those two past events triggered a lot of anxiety making in your memory and that make some investors instinctively referring to those experiences during another confusing time of the market.

There are two ways I find useful in overcoming experiential bias when thinking about when invest your cash reserve. First is focusing on the fair value of the investments versus its current price, rather than just the change in price. We have to admit the fact that we most likely will never buy at the absolute bottom of the market, but instead, you get into the market when the investment is undervalued to the range that is acceptable to you. For example, you don’t know where the market bottom is going to be, but you think it is acceptable for you to get into the market/sector/holding when it is traded a certain percentage undervalue, you can start invest your cash in increments when that percentage is reached (and overtime when the cost basis is averaging out, the result might be better than you think) instead of using past experience to estimate the true bottom of the market. And that introduced the second way to separate yourself from emotions - set a quantitative rule for yourself to trade in small increments periodically and follow your rules. The floor of each increment is determined by thinking about the least amount that you want to earn if the market goes exactly as you foreseen, and the ceiling of each increment is determined by thinking about how much loss will make you start to feel unacceptable if the market goes opposite to what you expected.

Herding

The market has been riding a roller coaster, and the past week we have been seeing some herding behavior from retail investors in the market. This is usually due to in time of uncertainty, investors are seeking safety in numbers believing that the collective decision is better than their own decision or thinking that other people have more insights into the situation and therefore reinforcing the herd behavior.

I include this concept here because I want to remind readers that herding is a very common cause of bear market rallies (which is why there were many 10+% bear market rallies during each of the market crisis in the past) because of their amplifying effect of the market sentiment. If you see the market moved abruptly without a solid reason (of course, given that you have been following the news and can interpret the market and economic effects instead of ignoring the reasons why the market moved), be aware that it might be the herding behavior. Not to say that the herding behavior are always in the wrong or might not turn into a self-fulfilling prophecy, but instead, it is important to recognize that some herding behaviors are irrational which is why, even though it sounds like a cliché, I still encourage investors to focus on your long-term investment strategy instead of chasing the market during volatility.

Regret Aversion

Another behavior I have seen recently is the regret aversion bias – several investors have discussed with me that they regretted not liquidating their entire retirement account into cash when the volatility just started and believed that if they did, they would have more cash in hand to invest at the bottom and therefore are seriously considering liquidating the majority or their entire accounts. This behavior, weighs more of the potential emotional pain of the fear of missing out than rational reasoning, is dangerous because without a careful planning in advance, this behavior triggered by regret aversion bias may have result in yet another regret - when after investors cash out of the market but fail to identify when and how to get back into the market, they could miss the return from market rebound.

The very first question I ask those who are thinking about liquidating their entire account is what’s your investment plan after you liquidate your entire account – if you don’t have one, that is how you know the decision of liquidating the account is not from your rational decision making because rational decision require you think about the consequences. So the best way to preventing yourself from acting on regret aversion is before you take action, thinking about your next steps – while you are thinking through and analyzing your next steps, it gives you room to think about whether your decision is made from true reasoning or regret aversion.

In Conclusion

Like Warren Buffett had said that in investing, you need to know what you are doing to do well. Before you make any big financial decisions especially during market volatility, exam your reasonings behind your decisions and make sure you did not make those decisions solely based on emotions, past experiences, or what other people are doing.

Hope this is an interesting read for you and please feel free to share it with friends who might also find the post interesting or useful :)

*Note that this article is for educational purpose only and does not constitute financial advice.