Mike Tyson famously said, “Everyone has a plan until they get punched in the mouth.”
The brutal “punch in the mouth” brought on by Covid-19 caused markets worldwide to collapse and the repercussions sent shock waves throughout our daily lives. It’s changed how we work, learn, shop, eat, interact and generally how we live.
Having a plan is one thing (and albeit it a very important thing) but being able to stick to a well-thought-out plan is equally important, as Iron Mike Tyson’s quote implies.
If you were not sure before 2020, markets are volatile and can move extremely fast. It’s best to think that we will get punched in the face from time to time and plan accordingly.
So how do we make sure our emotions don’t get in the way of our best judgement when we are getting punched in the face? The best time to build a resolute plan is prior-to, not during the barrage. A plan that anticipates getting punched in the face.
Why do we want to do this? Because our minds can be our own worst enemy under duress and we don’t want to change our plan when getting punched in the face.
Several years ago Daniel Kahneman, the 2002 Nobel prize winning economist wrote about System 1 and System 2 thinking in his seminal book, “Thinking, Fast and Slow.” He describes how System 1 thinking helps us make everyday decisions and react quickly when we need to, while System 2 thinking helps us make more purposeful decisions and work on more complicated tasks. For both System 1 and System 2 thinking, our minds try to save energy by using heuristics to make decisions more efficiently. And most of the time this works fine, but biases can pop up which can lead us astray – these biases can do real damage when we don’t even realize they are behind the scenes causing havoc. The challenge is to understand the biases we may have, the even bigger challenge is understanding the biases we don’t even know we have that are influencing us.
Psychologists and behavioral scientists have researched and documented well over a hundred and fifty different biases that can lead us astray when making decisions. We’ll discuss just a few biases that are particularly damaging when it comes to investing.
- Overconfidence Bias:
Do you believe you are an above-average driver?
If you said yes, you are not alone. 90% of all drivers in a famous study of everyday people said they were above-average drivers – myself included. Unfortunately, basic math tells us this isn’t possible. This is overconfidence bias. We all tend to be unrealistically optimistic about our chances of success and our abilities. When it comes to making investing decisions, this can result in investors thinking they can outsmart the market. This type of thinking leads people to believe they have a superior edge when in reality they do not.
- Confirmation Bias:
Confirmation bias is our tendency to find and interpret information in a way that supports our already held opinion. Confirmation bias can derail the best of us. Even if we engage in research before making a decision, our minds will naturally want to pay more attention to information that supports our current beliefs. Confirmation bias is such a powerful force even when you know about it, it’s tough to fully appreciate its grip on our thought process.
- Recency Bias:
Using the most recent past to support our belief that the future should be most similar to what has just happened. Our minds naturally reach for what happened most recently. This is partly due to our brains have an easier time remembering what just happened compared what occurred further in the past. While this works quite well in everyday life, it can result in placing undue importance on recent events when we make investing decisions. For many investors, this means that when their portfolio drops 30%, Recency bias convinces them that it will continue dropping.
- Herding Behavior:
Just as it sounds, Herding Behavior means following the herd. Most of the time, following the herd makes a lot of sense. If there is danger, running away from the danger along with the crowd is the sensible thing to do. However, during market volatility, many investors (the herd) can overreact, and not following the crowd is the right action, as the crowd is usually going in the wrong direction. Doing this can feel extremely unnatural, because most of the time going with the crowd makes sense. Doing the hard thing, is hard.
- Action Bias:
Research has found that the urge to take dramatic action can feel right when things are not going well. This is classic System 1 thinking, when in reality and statistically the correct choice is thoughtful (System 2 thinking) inaction. During times of volatility, sometimes resisting the urge to “Sell! Sell! Sell!” very well could be the right decision. Doing nothing while markets are dropping is extremely hard, because it goes against our instinctual nature to take action. In our minds, it hurts less to try something and lose, compared with doing nothing and possibly losing. If investors don’t calmly think about the appropriate course of action, and give in to Action bias instead, it can make their losses worse; but to them, it can feel better. “Well, at least you tried,” the common consolation can be comforting, but not the correct course of inaction.
Quickly Putting It All Together:
Here are a few things you can do to help make the best (System 2) decisions possible and overcome those nasty biases and unrelenting emotions.
- Understand how markets work and learn market history.
- Know what you own and why.
- Discover what biases may be lurking between your ears that may sabotage you – and fight like hell to overcome them.
- Gain access to an outside person to be able to bounce ideas off of and be able to voice your concerns is invaluable.
- Having a longer-term focus will help look past the short-term gyrations that the market and your portfolio will experience.
Cheers to an emotional and bias free investing future!
-Paul R. Rossi, CFA