As human beings we may not be wired to make good financial decisions. Behavioral finance points to anchoring bias and recency bias are just two of the many factors that influence our decision-making. If not properly addressed, these biases can have a negative impact on the foundation and long-term success of your financial plan, and they tend to present themselves most strongly at the tail-end of a bull market.
Anchoring bias is the tendency to use first impressions to form perceptions, which then tend to affect our later decisions. A common example of this anchoring effect for investors is that if you buy a stock for $100 and it later drops to $80, you are predisposed to still internally value it at $100. Investors tend to anchor the fair value of their positions to the original price they paid rather than what the market tells them the investment is worth. This can result in holding losing positions for far too long in hopes that they will return to their original price, even if they never do.
The other side of this anchoring bias in investing is a disposition effect. In this case, investors are still anchored to the initial purchase price of an investment and therefore feel more comfortable selling when they can realize gains, even if selling is not advisable at that time. When anchoring and disposition biases come together, it is easy to wind up with a portfolio full of poor investments, as we’ve felt inclined to sell our winners and hold onto our losers.
Recency bias is the belief that whatever happened in the recent past is going to happen in the future. This thought process is particularly dangerous in the last few years of a bull market, as many investors believe that the sky is the limit and markets are bound to continue moving upward. We are now in the longest bull market in US history, and it is not a coincidence that many investors are flocking to index funds in hopes of matching the return of the S&P 500, Dow, Nasdaq or whatever other index they feel is going to lead the charge.
Because the recent focus has been on how well these indices have performed over the last few years, many people tend to discount or completely forget about the negative volatility associated with these passive strategies. A critical detail that is often overlooked by individual investors is how their favorite index has performed over a full market cycle – from peak to peak or trough to trough. By taking a longer-term perspective you can not only be more prepared for the inevitable ups and downs of the markets, but can also cut out some of the excessive volatility from an overly-concentrated portfolio.
The question remains: How do you overcome behavioral biases that can negatively impact your portfolio and planning? The short answer is research, and a lot of it. Even with the most disciplined research approach though, it is also important to work with an objective financial professional who can help eliminate emotional decision making. These biases are just one reason why Atlanta Financial has such a uniquely robust and disciplined investment research process. All of us are wired to make decisions based on our emotions, which is why we at Atlanta Financial believe one of our main responsibilities as financial advisors is to help guide our clients to think more rationally and objectively about investing.