What We Do When We Don’t Know...

Humans have evolved to be great at many things. We are uniquely able, for example, to master complicated speech patterns and engage in complex reasoning. But the big brains that make these things possible can also get us into trouble. In situations where there is a lot at stake and where the outcomes are uncertain, we tend to get anxious. In many cases this response is quite rational. It keeps us from walking down deserted streets and eating unknown foods. But in investing, it can also lead to some pretty unhelpful behaviors.

The stock market is probably the best modern day example of an uncertain environment where participants have a lot at stake. Over short periods of time, stock price behavior is unpredictable and random. Why? Because human emotion, not economic fundamentals, hold sway over the short term. The resulting volatility can leave investors feeling out of control.

The field of Behavioral Finance has identified a number of psychological errors that investors routinely make to cope with their anxiety. To make sense of the wide variety of information that is thrown at them, many investors seek out only data that reinforces their current thinking (Confirmation Bias.) Herd behavior or the tendency to “jump on the bandwagon” of a hot stock or market is another example of Confirmation Bias. While the crowd may ultimately be wrong in buying the latest hot technology stock, at least you have the comfort of knowing you were not alone in your error.

Investors also have a hard time being patient in the face of stock price volatility (see Eric’s article page 1.) The tendency to react regardless of the circumstances (Action Bias) leads to excessive and costly over-trading. Individual and professional investors alike fall prey to this behavior. Consider that the average stock in a mutual fund today is held for less than six months.

Predicting the future is always difficult and no more so than in the stock market. In an effort to forecast stock prices most analysts construct complex earnings models. These models make assumptions on a wide range of variables, everything from input costs to competitor behavior. But as a starting point, these models use the recent past as a baseline for predicting the future (Recency Bias.) The 2008 nationwide sell off in real estate prices is just one example where assuming that the future will look like the past got investors into big trouble.

Story telling (Narrative Bias) is another interesting example of investor efforts to impose order on seemingly random events. Analysts and the press have coined the term “the Trump Trade” to explain stock price gains in early 2017. In this case, using a single narrative to explain market behavior caused many analysts to miss other relevant factors at work, such as the improvement in European economies.

The biases outlined above should not be surprising. Research has shown that investors feel the pain of a loss twice as much as the positive impact of a gain. But how can investors avoid their ill effects? Maintaining a long term focus is a good start. Take a look at the chart above. While stock prices can be quite volatile over the short term, over the long term they have moved up pretty much in lock step with corporate profits. Keeping this fact in mind should help calm frayed nerves during market downturns. Resisting the temptation to see a coherent story in data can also help. Simple explanations for complex issues can be comforting, but they are rarely accurate.