Volatile Markets and Behavioral Biases

After years of low and declining volatility, investors have had some adjustments to make in the last six months or so. Volatile markets, especially falling ones, can play tricks on the mind. None of us are immune to the various behavioral biases that have spawned the now popular field of behavioral finance. Being aware of those biases should help, however, and I recently decided to review the literature to be better protected from my own rationality. As a guide, I used Behavioral Finance and Wealth Management by Michael M. Pompian, which I would recommend as an introduction to the field.

Out of the 20 biases Pompian discusses, I have singled out 8 which I consider most relevant at this time. In order to keep my blog posts within reasonable length, I will divide these into two sections. The biases are separated into emotional biases and cognitive biases. This post will deal with emotional biases and the next one with cognitive biases. I am not making any specific recommendations, but merely reminding you to be aware of these common pitfalls.

Loss aversion bias

It is well documented that a loss brings more pain than a gain of the same magnitude brings joy. That aversion to loss brings a tendency to hang on to losing investments in hopes of a turnaround, however unlikely it may be, and conversely may lead to premature sales of profitable investments in order to lock in a profit. Beware of holding on to a losing investment longing for it to reach its purchase price. You could be waiting a long time and foregoing more profitable opportunities in the meantime.

Regret aversion bias

Fear of making the wrong decision can lead to indecisiveness or undue conservatism at the wrong time. The simple, but elusive, rule of buying low and selling high often means finding value in markets that have fallen. The regret aversion bias makes this difficult because people are least inclined to take decisive risks after their investments have been suffering.

Endowment bias

Endowment bias consists of attributing a higher value to an asset due to one’s ownership of it. People can get emotionally attached to even financial assets, a common occurrence in the case of inherited securities. Ask yourself this: If your holdings in the securities in question were liquidated and you suddenly found yourself holding cash instead, would you use that cash to purchase the same securities in the same amount as you currently hold? I frequently ask myself this question to determine whether my portfolio is really as I would like it, or if it is the way it is due to legacy or inertia.