Heightened volatility exacerbates most investors’ biases.
Identifying these influences is the first step in mitigating them.
The recent turbulence in the market has investors scrambling. If you took a step back and just watched, you’d have seen investor psychology play out in 3x speed over the last few weeks.
Usually, biases and psychological influences can be exacerbated in times of uncertainty. Look at how many people have something to say about the markets right now. The markets have taken center stage with the whole tariff situation.
Fund managers and government officials are frequenting news networks and constantly sharing their opinions via social media. It has made for a whirlwind of information and fresh hot takes each day.
I’ll be blunt here. Making any short-term forecast in this market seems outright stupid. Just this past weekend, we heard there was a tariff exemption for certain tech, phones, and chips, only to be told the exact opposite a few hours later.
You won’t catch me saying anything about where we go from here.
When it comes to investing, usually we are our own worst enemies. Humans are really horrible at leaving their investments to compound. The allure of getting tactical has beaten retail investors time and again.
Today, I will outline a bunch of different psychological factors that can influence our investments.
Herding: When you think of herding, think of FOMO. A group of people with the same investment beliefs can be dangerous. Wall Street itself has been compared to one giant groupthink. When we start blindly hitting buy or sell based on what everyone else is doing, we are no longer acting in our best interest. We are taking some information or advice at face value, without actually thinking of the repercussions to our individual situation.
Memecoins and memestocks are a great example of herding. The idea of “value” is completely removed from these phenomena.
Mental Accounting: I see this on a daily basis. I do this on a daily basis. This occurs when you start separating out funds, expenses, or even assigning different values to funds.
Gen Z has even gone as far as to make the claim that spending cash is not actually spending at all. Of course, we know that it is, but it feels different than when you swipe the card and your apps update.
For Gen Z, when money never existed in their bank account, it “never existed at all”.
We see this in practice all the time. Sometimes folks prefer to set up a “vacation savings account”. This is simply just another account that could be used to fund a vacation. We view it no differently than one’s cash reserve. It is simply just additional cash with a new label on it.
Generally speaking, a solid cash reserve should be able to afford someone a vacation! We use the reserve for emergencies and opportunities!
Loss Aversion: This is one of the most relevant influences on investors. Loss aversion describes the idea that losing hurts more than winning feels good.
You know what feels good? Back-to-back years of the S&P 500 clocking over 20% returns. You know what feels horrible? Watching the S&P 500 drop 18% from the all-time high.
We just experienced this! How did you feel? Did the loss hurt way more than the gains felt good?
Loss aversion can lead to irrational actions in your portfolio. Especially when you couple it with uncertainty. There are legitimately people who sold the bottom on April 8th. The S&P 500 is up roughly 8% from that low.
You have to take the good with the bad. There is no avoiding it, unless you want to seriously jeopardize your annual returns.
Illusion of Control: This one is relevant right now. Especially because we have absolutely no control over what is going on.
Believing you have much control over the market in the short term can get dangerous and even lead to other biases, such as overconfidence.
Be careful with how much weight you think your thoughts, opinions, and actions have on capital markets.
Recency Bias: Recency bias can be incredibly hard to overcome for a lot of investors. Usually, getting burned once or twice will teach you the lesson.
Essentially, it is allowing recent events to have more influence on your actions or decisions.
Imagine being a young person who began investing at the bottom during COVID. You literally only experienced stocks going up. Which is true over long periods of time, but this was extreme instant gratification. You could find a ticker and then be 5% richer by the next day.
This can have a massive impact on people’s ability to think rationally about their investments and can heavily sway their perceived risk tolerance.
Confirmation Bias: I struggle with this one myself. I am generally an optimistic person, I want to hear good news about the markets. I will even seek it out during times of volatility, such as the last few weeks.
Finding research that only supports our opinions without any that negates it is a dangerous thing.
It is important to be aware of everything going on and see both sides of the story. Maybe it is not a great time for the market, and although I am positive in the long term, that isn’t reflective of what is going on currently, and vice versa.
Being able to see both sides of the coin makes for a well-informed individual.
These influences stand to make even the most rational people make rash decisions. They are wildly hard to mitigate, but understanding them is the first piece of the puzzle.
Next time the markets get volatile or euphoric, think back to this. Are you taking a herd mentality? Are you mentally accounting for things in a way that isn’t sensible? Did that 5% drawdown hurt a lot more than when the markets went up 5%? Do you think you have more control over an investment than you really do? Are recent events influencing your current mindset? Are you taking a holistic view, or are you only consuming information that conforms to your initial opinion?
Keeping your wits about you will pay dividends over the course of your career. And the best part is that these dividends are not forced taxable events. (Little humor there for you guys. I’ll see myself out.)