There are measures investors can take to counter cognitive biases and stay poised in a difficult market environment, such as has been the case since the pandemic broke out.
The following comments come from Sandra Dailidyte, client senior manager at Brown Shipley, the UK wealth management firm. She writes about the kind of steps people should take as and when they suffer a blow to their investments. The editors are pleased to share these comments; the usual editorial disclaimers apply. Email firstname.lastname@example.org and email@example.com
The COVID-19 pandemic has sent ripples through all aspects of our lives and the stock market is no exception. As the virus took hold and spread globally, the level of investor panic sent us into the fastest bear market in history. The value of many individuals’ investments took a sharp dip over a matter of days.
So, what is the best way to cope when you see the value of your portfolio going down suddenly? By 10 per cent, then 20 per cent, or even more, depending on your risk profile?
Without an investment background, and in-depth knowledge on past market crashes and recoveries, an unexpected drop can be overwhelming. It can cause the mind to play tricks and go into overdrive, leaving many with an inaccurate view of their situation, and potentially making ill-informed decisions.
Two behavioural economics terms are useful to examine here: these are ‘hindsight bias’ and ‘loss aversion’. The first one, also known as, ”I knew it all along”, is a widely studied decision-making trap. It refers to the tendency for people to overestimate their ability to predict an outcome that could not possibly have been predicted. The second cognitive bias - loss aversion - is based on the concept that the relationship between risk and return is not symmetrical. This means that we feel much more comfortable with ups rather than downs, which explains why we are so anxious about losing money. To put this in practical terms, I expect many would be more concerned with a 10% loss in their portfolio than they would be excited by a 10 per cent gain. Making money is logical, losing money is emotional.
The key to removing these biases is so hard, and yet, so simple. Knowing that your mind plays tricks on you is half of the battle. Then, you simply need to step back, and think logically.
With all of this in mind, below is a list of five top tips - taken from discussions with a number of investment professionals and experts in psychology - that could help you outsmart your cognitive biases, and keep your head high in the current environment:
1, Think not feel
Investing is a rational process, so firstly try not to let your emotions take over. If a sudden drop in value or volatility is making you feel anxious, perhaps initially take a step back and do not look at the portfolio every day for a period. Remind yourself that you are investing for the next 5, 10 or 15 years and focus on the long term.
2, Stay invested (for the long term)
History tells us that markets often recover, and sometimes quicker than expected or you are able to react to. Capital can be destroyed with poorly advised exit and re-entry into the market – big rallies can often follow large corrections, and missing these can damage potential long-term returns.
3, Paper losses
Unless you have sold the investments, these losses are not real – they are ‘paper losses’. Reminding yourself of this fact can be powerful. If you believe that a company has good long term prospects, it is worth hanging on through this turmoil – which could be temporary. This leads us nicely on to our next tip…
4, Take a logical look at the companies that have fallen in value
What are their prospects of recovery? Perhaps it may be worthwhile cutting some losses and reinvesting in companies that provide better recovery characteristics for the rebound. Also, think of it as bargain hunting.
5, Stick to the plan
Investing should never be guided by specific moments in isolation; it should be a part of a process over time. If you do not have a long-term financial plan, creating one—and sticking to it—is the best action you could take at this time. If you do not know where to start, always seek professional advice.