Humans are emotional creatures. Our emotions can be very beneficial and helpful. Emotions can also deceive us and lead us into wrong thinking and bad decisions. Emotions can also help build bias in our thinking. Bias can be for or against things familiar or things unknown or different.
In psychology, there many types of memory bias. Some of these biases may often have effect on investors.
One of these biases is called, “Fading-affect bias.” This bias refers to a situation in which a person’s unpleasant memories and the emotions associated with it tend to fade from memory faster than positive memories and emotions. Another is, “Near-term bias.” Near-term bias refers to the tendency of a person to think that the way things are currently is how they will remain.
The current stock market gains are causing some to suffer from a combination of both of these biases. Since the stock market is going up so much, some people believe it is bound to continue and they begin to regret having bonds and cash in their portfolio. They start thinking, “I could have done so much better. I need to put more or all my money into stocks.” That is the near-term bias talking.
At the same time, many of these same people may suffer from the fading-affect bias. The same person asking, “Why am I not all invested in stocks?” is likely forgetting the emotions and even fear that they experienced in 2008 and 2009. Some of these people were very scared and endured very negative emotions, even if, in some cases, a significant percentage of their portfolio was in bonds and cash.
The combination of these two biases can have a powerful affect on people and the perception of their portfolio strategy and allocation. The temptation is to abandon a more diversified portfolio in favor of one more allocated to stocks, or even completely to stocks. Should the market suddenly turn on these people, the faded memory may reignite the old emotions of a down market and make them susceptible to making a decision based on fear, not rationality.
Given the run up in the stock market, many investors currently have more allocation to stocks than their strategy might dictate. For example, if an investor’s portfolio strategy is to have about 65% stocks, 30% bonds and 5% cash, they may now have something like 70% stocks, 27% bonds and 3% cash (remember, as the portfolio goes up in value the cash holding as a percentage is reduced). While the near-term bias may make the investor want to increase stock allocation even more, the correct response would likely be to take some profits from the stocks and rebalance back to the target allocations. If stocks continue to climb, then the investor may soon have more profits that could be taken; the investor is not missing out, but still participating with the appropriate amount of risk in the portfolio. If the stock market should reverse and the investor find that the allocation has become 60% stocks, 33% bonds and 7% cash, then it might be a good time to sell 3% in bonds, take 2% from cash and buy stocks back to 65% of the portfolio.
The correct way to invest is to devise a portfolio strategy based on sound financial planning that is appropriate and prudent for the individual or family. This strategy should have taken into account the investor’s tolerance to market swings in order to help avoid the mistake of panic selling in downturns.
An investor with an appropriate allocation based on sound planning should resist the temptation to change the overall strategy in the direction of current market trends. Often, the prudent and wise thing to do is to rebalance the portfolio back to the target allocation. Investors who understand how their strategy was devised and why the strategy allocation is what it is should have a much easier time resisting common biases that lead others to make mistakes.
Richard Tomes, CFP®