Bear Market Behavioral Biases—Are You Sure About That?
Published on Proactive Advisor Magazine March 10, 2021
Bear markets trigger powerful emotions for many investors. Awareness of investor biases—which are compounded in bear markets—can help both advisors and their clients avoid making behavioral mistakes in turbulent times.
It might seem strange to be thinking about a bear market when the U.S. equity market has recovered impressively from the 2020 COVID-induced market swoon. But the current environment of strong market returns is the best backdrop for thinking about how you—whether an advisor or individual investor—should respond to the next bear market (typically defined as a drop exceeding 20%).
Such events trigger powerful emotions that lead to poor investment decisions. As an example, we had a financial advisor pull millions of dollars out of one of our portfolios right at the bottom on March 23 last year. He thus locked in a significant loss and, in turn, very likely missed much of the ensuing dramatic bounce back. This is one of the common patterns in such market movements: The largest gains follow closely on the heels of the largest losses. Locking in the large loss, then missing the large gain, is a wealth-destroying double whammy.
How we make decisions
Over 95% of human decisions are made using “System 1 Thinking,” which is automatic and uses mental shortcuts. “System 2 Thinking,” by contrast, requires conscious effort with logical thinking and analytical methods.
Long-term investing is often counterintuitive and requires a disciplined System 2 approach. Bear markets compound our normal biases, generating strong emotional triggers that can result in poor decision-making.
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