How to Avoid Biases that Can Undermine Your Portfolio

A Lesson in Behavioral Finance in the Era of COVID-19

by Rebecca Meares, CFP®

Generational traits are often shaped by the major social, economic, and political milestones of the time. Values and behaviors develop in response to these defining experiences and influence how we make financial decisions moving forward. After witnessing the 1929 market crash, Depression-era Americans were famously known for their aversion to the stock market and preference for cash under the mattress. Many millennials graduated during the Great Recession with piles of student debt and low job prospects, leaving them disillusioned with Wall Street and reluctant to enter the housing market.

Experiences like 9/11, the technology boom, and now the COVID-19 pandemic affect the way we save, spend, and invest our money. But are these emotionaland psychological-based decisions the best avenue toward financial success? While we wait to see how the COVID-19 crisis will affect long-term investor behaviors, we can identify and overcome three common biases that transcend generations and tend to lead us off course.

Recency Effect Loss Aversion

Recency effect places greater emphasis on events that occurred most recently. As the memory of 2008 had faded with the 11-year bull-market run, so did the pain of the losses endured. With major stock market indexes up over 20% in 2019, many investors let their portfolios drift to more aggressive levels than they may have been previously comfortable with, only recalling their most recent market successes. As a result, many were in for a rude awakening when their account values plummeted with the excess embedded risk. On the other hand, when a portfolio drops 10%, recency effect convinces us it will keep on falling even though market pullbacks, and subsequent recoveries, are fairly common. Disregarding the full picture to place undue importance on recent events can get us into trouble as we make snap choices.

Do not let this most recent downturn cloud your longterm vision and investor behaviors. Stick to your plan and maintain a methodical approach to your investment process.

is the notion that humans psychologically experience the pain of loss more acutely than we feel the joy of gain. It has been nearly impossible to remain stoic in the face of the wild market swings this year. Even if your portfolio made a full recovery, the turbulence likely caused added stress and feelings of pain. The powerful negative emotion associated with loss may cause an investor to overestimate the risks associated with a portfolio, which can be counterproductive to strategies for long-term success. Changing strategies, like selling during a moment of panic to avoid the pain of potential losses now can end up hurting significantly worse in the long-term. Take emotion out of the equation. Start with a strong understanding of your risk tolerance and how it compares to your portfolio. Consider how your investments may behave in both good times and bad. Also, speak with your financial advisor about strategies that may take advantage of market fluctuations, like dollar cost averaging or tax loss harvesting, if appropriate. Finding silver linings may help you stay focused.

Bias

Herd bias speaks to our human nature to follow the crowd and believe, “If everyone else is doing this, it must be right.” Even if you are adept at managing your internal voices, it can be challenging to go against the grain. Investors may disregard the information and analysis at hand to blindly follow the actions of others, especially in times of crisis. Between the constant news updates and chatter amongst social circles, it can be challenging for even the most rational investor to stay on track. Irrational optimism and excessive pessimism amongst groups often play significant roles in bubbles and crashes. Think back to those who cashed out in 2008, only to have missed the significant rebound that kicked off the longest bull run in history. Or how about the irrational optimism in the late ‘90s that enticed so many to invest in internet companies that were not financially sound, only to be disappointed when the tech bubble burst?

Do not make any sudden changes. Disregard investment fads and group-based fears, and chart your course based on solid data and your own personal financial plan.

If 2020 has taught us anything, it is to expect the unexpected. We cannot plan for every possible scenario or completely set aside our emotions, but we can manage our behaviors and design strategies to safeguard against potentially imprudent decisions. So, when the next black swan event does occur – be it a pandemic, a natural disaster, or a zombie apocalypse – are you prepared to overcome those irrational internal voices and make wise decisions for long-term financial security and success? Make sure you have a sound financial plan in place and reach out to the experts for help.

Rebecca Meares is a CERTIFIED FINANCIAL PLANNER™ professional at Caudle Meares Wealth Management, in McLean, VA. The firm’s mission is simple: to empower clients to live the life they desire, knowing they are financially secure. Contact Rebecca for a complimentary consultation at rmeares@cmwealth.com.