Volatility is heightened right now.
We have volatility in markets, government policy, trade and supply chains, which translates into emotional volatility.
Let’s look at some of the ways this manifests through a host of behavioral biases that impact us all in some way:
Recency bias is when you give more weight or importance to recent events.
Stocks are up. The correction is over!
Stocks are down. This downturn will never end!
There is a tendency to declare victory — either bullish or bearish — when the stock market is rising and falling rapidly.
The volatility plays head games with you.
Loss aversion is the most important concept in finance. Losses hurt twice as bad as gains make you feel good.
The 10% correction last week on Thursday and Friday makes you feel twice as bad as that 10% up day from this past week.
The gains don’t have a chance against the losses when it comes to your emotions and that can cause mistakes.
The more often you look at the market or your portfolio, the worse you’re going to feel. This is always true but is even more amplified during volatile markets.
Confirmation bias comes from seeking opinions or data that agree with one’s pre-existing beliefs. With the Internet, 24/7 news, and social media, it’s never been easy to seek out only those opinions you agree with.
If you want a bullish take on the market, the economy or a stock pick you can find it. If you want a bearish take you can find that too.
When markets and emotions are all over the place it makes you feel better seeking out opinions that match your own.
Those opinions can be useful if they help you stick with your investment plan but they cannot help predict what comes next.
The stock market doesn’t care about opinions, just facts, data and trends.
Anchoring is when a default starting point influences your conclusions.
Investors often anchor to a stock’s cost basis, all-time high or low levels and the last price on the screen. Making investment decisions during volatile markets while anchoring to specific price points can cause problems.
I’ll just sell when I break even.
I can’t buy that stock now look where it was trading at in the depths of the correction.
Sure the market is down 15% but I’m not buying until it’s down at least 30%.
Obviously, the price you pay for an asset matters but investment decisions shouldn’t be held hostage by an arbitrary value.
Hindsight bias is the assumption that the past was easier to foresee than it actually was. Hindsight is always 20/20 but never in the moment.
Whatever happens with the trade war will look obvious with the benefit of hindsight.
I knew Trump was going to slap tariffs on the rest of the globe — he told us that in his campaign!
I knew this was all a negotiating tactic!
However this plays out it will feel obvious and everyone will act like they knew all along.
I don’t know how or when the current volatility will subside but I do know a lot of people will pretend like they saw it coming from a mile away after it happens.
Endowment bias occurs when you place a higher value on something you possess.
The stocks I own are all undervalued. The stocks everyone else owns still have a long way to go to reach fair value.
This is the reason homeowners have a difficult time making price cuts. You always think the thing you own is worth more simple because you own it.
Gambler’s fallacy exists when you see patterns where none exist in sequences of random events.
This is your friend at the casino who thinks red has a better chance of hitting on the roulette table after black hits a few times in a row.
The stock market was down yesterday so it should snap back today.
The stock market was up yesterday so it should continue rising tomorrow.
Momentum exists in the stock market but most short-term moves are random or nearly impossible to predict.
The illusion of control is the belief that you have control over uncontrollable outcomes.
Studies show people are willing to pay four times more for a lottery ticket if they can pick the numbers rather than a random selection. The odds are the same either way but people like that feeling of control.
Investors have a tendency to grab the steering wheel to take more control during market downturns.
Doing more often leads to subpar results, especially when emotions are high.
The sunk cost fallacy is when your decisions are determined by investments that have already been made.
If you were starting from scratch today and your entire portfolio was all cash, would you still hold the same mix of assets? Or would your portfolio look entirely different?
Sometimes you hold onto investments simply because you already bought them.
The same is true of investment opinions. People often hold onto certain views too long and won’t change their minds simply because it required a lot of time and effort to come up with those views in the first place.
This leads to more confirmation bias even when there is evidence to the contrary.
There’s a laundry list of behavioral biases we all succumb to that can lead to regret as investors.
Research shows that investors hold onto losing stocks too long in hopes they will come back to their original price while selling their winners too early.
Investors also anchor to recent results, so initially markets underreact to news, events or data releases. On the flip side, once things become more apparent, investors are prone to herd mentality, leading to overreactions.
This is what causes markets to overshoot in either direction, as the pendulum between fear, greed, overconfidence, and confirmation bias can lead investors to pile into winning areas of the market after they’ve risen or pile out after they’ve fallen.
It’s all interrelated depending on your actions, reactions and emotional make-up.
The worst bias is typically the one you see in others but fail to recognize in yourself.
Everyone has a lesser version of themselves you need to watch out for when volatility strikes.1
This is why an investment plan is so important during times like these.
Human nature is out to get you.
Further Reading:
How to Survive Chaotic Markets
1I tend to buy too early because I’m a glass-is-half-full kind of guy. When panic sets in and the stock market is crashing I can’t help myself. This is also why my best purchases tend to be of the automated dollar cost average variety.