Behavioral Risks in Bear Markets

Joe Wiggins writes on his blog that it is at times of severe market stress that our worst behavioural impulses come to pass. Whilst the recent losses in the value of portfolios are undoubtedly painful; the poor decisions that we will make as a result of the torrid environment will likely prove more damaging to our long-term outcomes. Against such a turbulent market backdrop, which behavioural issues should we be most concerned about?

Myopic Loss Aversion: Short-term losses are difficult, but they are also an inevitable feature of investing in risky assets.  Indeed, the high long-term returns from equity investment are a consequence of their volatility and the potential for severe losses – to enjoy the benefit you must be behaviorally disposed to bearing exacting periods.  For most investors (particularly younger ones) it makes sense to reframe the issue – rather than markets falling precipitously we should think about the likelihood that long-term expected returns from risky assets are now materially higher.

Recency: Our obsession with recent and salient issues means that they overwhelm our thinking.   Whether it is trade wars, Brexit or coronavirus.   This is not to say that such issues are not important but from a long-term investment perspective they are less vital than we think and feel they are at the time.  Try to make investments on the basis that we have to leave them untouched and unseen for the next ten years.

Risk Perception We are poor at judging risks.  We are prone to ignoring certain threats whilst hugely overstating others.  Our judgement about the materiality of risk tends to be driven by its availability (how aware we are of it) and its emotional impact on us.  The coronavirus is a particularly harmful risk for investors both because the magnitude of the impact is highly uncertain and it is deeply salient.  We also need to be clear about what risks we are considering when making an investment decision – is it the risk of short-term losses, the risk of being whipsawed by volatile markets, or the risk of failing to meet our long-term objectives?

Overconfidence In the past three months everyone has become an expert in virology, despite having no previous grounding in the subject.  It is okay to have an opinion, but the vast majority of people are guessing, and nobody knows the near term market or economic impact of the virus.  We shouldn’t make investment decisions that suggest we do.  In these environments making sensible long-term investment decisions is highly likely to leave us looking foolish in the short-term.  This doesn’t mean, however, we should not make them.  The advantage of being able to invest for the long-term is at its greatest when it is the hardest thing to do.  The only way to benefit from this is to have a sensible investment plan that is clear about objectives and the decision-making process.