LAST WEEK, I REFERRED to the stock market as a hall of mirrors. That was perhaps too kind. With its erratic and often illogical movements, the market also has elements of a pinball machine, a rollercoaster and maybe a clown car. This has always been the case, but it feels especially true this year. There’s one silver lining, though. The market’s recent behavior highlights many of the behavioral biases we read about in textbooks.
Consider recency bias, which is investors’ tendency to extrapolate from recent experience. When the market’s been going up, we tend to believe it’ll keep going up. When it’s in a rut, it’s hard to imagine what might make it go up again.
This year, however, has seen an unusual mix of data. Many financial metrics have been positive, including GDP growth, corporate profits and unemployment. But we’ve also seen rising inflation and we’re living under the constant cloud of new COVID variants. As a result, recency bias has been replaced by a sort of Rorschach test. Optimists see an economy that, despite the pandemic, is fundamentally healthy. Pessimists, on the other hand, see a supply chain that remains snarled. They note that dozens of stocks are in negative territory this year despite the overall market averages being positive. Result: Many investors are unsure what to think.
In one sense, this is good. Recency bias is often a trap, so this year’s conflicting signals are a positive insofar as they help us avoid extrapolating market developments in either direction with too much confidence. In other words, the silver lining of an up-and-down market is that it provides a useful reminder that the market can and does move to the beat of its own drum. We should never be too sure that tomorrow will look like today. As we head into 2022, I think that’s one useful lesson to keep in mind.
Anchoring is another bias that’s been a challenge for investors this year. What’s anchoring? Suppose you own a stock that you bought at $650 a year ago and today it’s trading at $1,000. Most people would be happy with this result and happy to sell it at this level. But if the stock had been trading at $1,200 a few months ago and has since fallen back, you might be upset, even though you’ve made money since buying the shares for $650. If you own Tesla shares, these numbers might look familiar. But this phenomenon isn’t limited to Tesla. In today’s environment, owners of many stocks—especially those of highflying companies in tech and biotech—are struggling with the effects of anchoring.
Fortunately, there’s a straightforward solution: rebalancing. If you have a target asset allocation for your portfolio—say, 70% stocks and 30% bonds—you don’t need to worry so much about where any investment has been. Instead, you simply need to look at your current allocation, compare it to your portfolio targets and rebalance accordingly.
Another bias to consider is what retired poker champion Annie Duke calls “resulting.” The idea: It’s a mistake to judge the quality of a decision solely by its outcome. That’s because of the large dose of luck—sometimes positive, sometimes negative—that impacts every investment outcome. Good decisions can have bad outcomes due to bad luck, while bad decisions can have good outcomes simply because of good luck.
Let’s come back to Tesla. If you’d invested your entire net worth in the company’s shares at any point over the past 10 years, you would have beaten the overall market by many thousands of percent. But you would only know that with the benefit of hindsight. Yes, the result would have been great. But to call such a large, undiversified bet a good decision would be an example of resulting.
By the same token, if you’d started out 2021 by taking a more balanced approach—investing carefully via dollar-cost averaging and diversifying globally—your results would have trailed the overall market and certainly trailed Tesla. You would have been better off concentrating your bets on a handful of tech stocks and doing nothing else. But again, that’s only with the benefit of hindsight. That would be resulting.
In a year like we’ve just had—a year in which “meme stocks” entered our vocabulary—investors may be more susceptible than usual to resulting. The lesson: As you evaluate your portfolio, try hard to consider not just your results, but also your decisions. To put it another way, it’s okay to take a balanced approach to your investments in 2022 even if you saw people make fortunes doing the craziest things in 2021.
Perhaps the most famous concept in behavioral finance is Prospect Theory, developed in the 1970s by Daniel Kahneman and Amos Tversky. They were the first to recognize that people dislike losses about twice as much as they enjoy gains. For example, an investor would need to experience a 10% gain to offset the pain of a 5% loss. Just as anchoring has upset many investors this year, so too has our disproportionate aversion to losses.
Consider the S&P 500’s monthly returns this year: In January, it was down. Then it went up for seven months in a row. After that, it oscillated between negative and positive for four months. As I noted a few weeks back, the market sometimes even alternates between negative and positive on a daily basis. That’s normal. But because of Prospect Theory, it can nonetheless be upsetting. Also, if you’re like most people and have seen your portfolio grow in recent years, the losses in dollar terms are now larger when the market has a down day.
What’s the solution? I used to have a colleague who started her review of any investment by looking at a 10-year chart. Then she’d shorten the timeframe to five years and then three. Only then would she look at a one-year chart. Her objective was to avoid evaluating anything through too narrow a lens. That approach, I think, makes a lot of sense. That’s because the reality is that you could find a timeframe over which virtually any investment will look like the world’s best investment or the world’s worst.
The bottom line: It would be glib to say the solution is to avoid looking at your investments too frequently. For many people, that’s easier said than done. But when you do look, I recommend taking my colleague’s approach. Never mind what an investment has done lately. Instead, ask what it’s done for you over the entire period that you’ve owned it.
How much should you really care about behavioral biases? According to a recent study by Morningstar, the impact is real—and it can be significant.