By: Joseph V. Goldy, AAMS®
In my previous two articles, we looked at how loss aversion and overconfidence both can have a negative impact on an investor’s returns. As with other potentially damaging behaviors investors demonstrate, they often go undetected until someone points out what is happening.
That is what makes investor psychology and behavior so fascinating to study. Intelligent human beings can rationalize various behaviors in their mind as they make investment decisions without ever realizing that they are exhibiting detrimental actions that will wind up costing them in the long run.
My hope is that by highlighting some of the more common behavioral challenges in this series of articles, you will avoid them altogether. The last of these we will look at is called anchoring and how it has the potential to distort an investor’s view of the past.
Observing the recent bull market which began in 2009, we can see anchoring play out in the decisions of average investors and how it has impacted their portfolio management.
What is Anchoring?
Anchoring refers to the way investors tend to latch on to certain beliefs and, despite witnessing contradictory events unfold, refuse to change their behavior in the face of that new information.
For instance, with the bull market moving higher every year since 2009, save for 2018, many investors were “anchored” in the belief that it will continue to do so.
Specifically how this is dangerous to an investor achieving their long term goals is when it causes a reluctance to perform basic risk management techniques or worse, lulls someone into thinking they are managing risk when in fact, they are not.
Taking this further, if an investor is “anchored” in the belief that stocks can only go up, they may choose to hold off on rebalancing their portfolio when the market is rising quickly. An investor that is in a 50/50 portfolio of stocks and bonds based on their risk tolerance and who does not rebalance, may find their portfolio has grown to a 60% or 70% allocation to stocks over a short number of years depending on how the market performs. Ultimately, this would mean the investor has more risk in their portfolio than they originally felt appropriate.
Normalcy Bias
A close cousin to anchoring is normalcy bias, which is where investors refuse to act in the face of a major event that they have never experienced before. The September 11 terrorist attacks, the financial crisis of 2008, and the current pandemic all qualify as black swan events investors have never lived through and therefore can cause a normalcy bias as they position their portfolios. Investors often do not prepare for events that have never happened in their lifetimes, if ever.
However, this is precisely the reason for a risk management strategy - to mitigate the unforeseen. Normalcy bias is pervasive even in the biggest organizations.
I read an article on Inc.com recently about how normalcy bias was one of the factors that led to the Boeing 737 Max problems. Essentially, the article was highlighting the irony of how the overall safety of the airline industry, and Boeing planes specifically, over the years has caused accidents to become rare, which then became the new “normal”. This caused Boeing to fall into a textbook normalcy bias situation where they were not preparing for all potential disaster scenarios.
Ultimately, whether it is anchoring or normalcy bias, both can cause an investor to put an unwarranted emphasis on recent market performance, thereby overlooking the importance of a possible game-changing event.
When new information is presented, investors can overcome both biases by remaining objective and taking a more analytical and systematic approach to managing their portfolios.
Author’s Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.