By Skyline On Friday, June 08 th, 2018 · In

FIELD NOTE: JULY 2018

COGNITIVE BIASES: PART TWO

In our previous Field Note, Skyline introduced several cognitive biases and explained how they cause poor financial decisions. While research on the financial effects of cognitive biases is still lacking, we can use the Consumer Confidence Index (CCI) and the Michigan Consumer Sentiment Index (MCSI) to compare investor sentiment to real economic conditions.

The CCI and MSCI poll Americans on a monthly basis and ask numerous questions regarding consumer’s attitudes on business climate and the economy. Generally, the two measures track with the general trends of the markets; however, there are periods that display little correlation (e.g. 1984-1986). Periods of inverse relationship among the S&P 500, CCI, and MSCI demonstrate how cognitive biases can get the better of us; framing and recency bias may lead us to believe that current economic conditions will continue indefinitely (i.e. 1991-1995 decreased consumer confidence following a brief bear market), while the bandwagon effect may cause us to adopt the anxiety and fear of others (i.e. the steep, predictive downward trend that occurs circa 2008-2009). Skyline has graphed the S&P 500’s variance (in percent over or under its trend line) and compared it to the CCI and MSCI below. Although causal relationships are purely speculative, pockets of inverse relationships demonstrate illogical investor sentiment.

Variance of the S&P 500, CCI, and the MCSI over or under their respective trend lines (1978-2018).

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Thankfully, research has shown that feedback and graphs (such as the one above) can mitigate the impact of cognitive biases. Skyline encourages its clients to contact their financial planner for a wealth of scientific research and logical feedback. Below are five additional cognitive biases for which to be aware.  

Bandwagon Effect

A tendency to follow the majority even if it goes against personal belief. Can cause inappropriate risk and speculative trading.

Example

Buying Apple stock because everyone is talking about it, even though buying individual stocks is not a part of your investment plan.

How to Avoid

Ignore the hype and stick with your investment plan. Remind yourself that investing follows trends, and investments that work well for others may not be appropriate for you.

Loss Aversion

An investor’s tendency to prefer avoiding losses to acquiring equivalent gains. Loss aversion can cause inadequate risk and unnecessary anxiety over cyclical market fluctuations.

Example

A young investor fears losing their hard-earned savings and invests in an unadvised low-risk portfolio.

How to Avoid

Acknowledge that loss aversion is a natural emotional response, and accept that loss is an inevitable aspect of investing. Refrain from checking market changes on a daily or weekly basis to avoid undue anxiety. Stick with the risk tolerance profile agreed upon with your financial planner.

Recency Bias

A tendency to evaluate and extrapolate investment decisions based on recent market performance while ignoring long-term trends. Recency bias can cause active trading and trend following (i.e., buying high and selling low).

Example

Years after the 2008 Financial Crisis consumers were still afraid of investing, assuming the bear market would continue.

How to Avoid

Stick to a financial plan and only make portfolio adjustments based on life changes, not on market fluctuations. Call your advisor when you feel anxious in bear markets; Skyline advisors welcome calls of concern.

Ostrich Effect

A tendency to avoid exposure to potentially negative financial information. The ostrich effect is commonly observed in bear markets; individuals check on their investments 50% to 80% less often in down markets. While typical news avoidance is an effective coping strategy in down markets, extreme cases of the ostrich effect can be an indicator of financial anxiety, and can impede necessary life functions.

Example

A middle-aged individual is overwhelmed by the prospect of retirement planning and afraid they are behind in their savings. They avoid having financial conversations with their spouse and refuse to speak with a financial advisor.

How to Avoid

Depending on the severity, either call your advisor or contact a therapist. While Skyline’s advisors are eager listeners and well-versed in financial planning, they cannot substitute for a qualified mental health professional.

Overconfidence

An investor’s tendency to overestimate their judgment or abilities relative to others. Overconfidence can cause inappropriate risk allocation, active and speculative trading, and lack of consideration of expert opinions.

Example

An investor actively trades penny stocks because they believe they can beat the market.

How to Avoid

Acknowledge that most people regard themselves as “better” than average in regards to skills or personality traits. Refer often to expert’s opinions and focus on statistics rather than intuition.

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