By Prasad Ramani
From the end of 2016 through the first three quarters of 2018, investors saw the Dow Jones Industrial Average shatter benchmark after benchmark, reaching heights that once seemed beyond comprehension. It became the longest bull market in history, and some believed it would never end.
But by October 2018, a historically volatile month for the markets, a new narrative began to unfold: namely one of turmoil and uncertainty. Shortly after we turned the calendar to 2019, the dim outlook grew dimmer: The share price of Apple (Nasdaq: AAPL) fell by nearly 10 percent in a single trading day, as financial journalists in some of the most respected publications told us that our worst fears about the markets were beginning to take hold.
If nothing else, we are reminded of just how fickle the markets can be. Investors and wealth advisors have little power, if any, over this reality. But what we have a greater control over is even more consequential: how we make decisions in the markets.
This may seem obvious to some readers. And yet, most investors and their advisors do little to improve how to make decisions. Far too often, we are indifferent to the underpinnings of our decision-making approaches. In other words, we don’t understand why we do the things we do; we just do them.
But research shows that if we are aware of the mechanisms that influence why we behave the way we do, we are better able to avoid the pitfalls of our subconscious biases that lead us to make bad decisions—especially those affecting our portfolios.
Self-, Not Market-Driven, Victimization
Before we get to the seven factors that influence decision makers, we need to take a look at recent market history to understand just how much bad decisions in a given market can spell disaster for a portfolio...
The last time Apple’s stock suffered a drop like what happened the first week of January was in the summer of 2015. Concerns pertaining to China sent the stock tumbling (Sound familiar?). Investors gave in to the jitters, and in just over a month, the share price of Apple dropped more than 20 percent to about $103. By January of the next year, the price had fallen below the $100 threshold.
Fast-forward to less than three years later: In the midst of unprecedented market highs, in history’s longest bull run, Apple became the first trillion-dollar company in the United States, with share prices exceeding $232 in October 2018. Those who succumbed to the jitters in 2015 missed out on the opportunity to more than double their position in just over three years!
Many of those investors, it’s probably safe to say, weren’t making sound decisions based on their investment time frame. Or, perhaps, they were unaware that they tend to be deeply affected based on what they read in the papers and react without researching thoroughly. If these people didn’t sell Apple in August 2015, who knows? Maybe they would be a few years closer to their retirement—or even already be there.
The Seven Factors to Master for Yourself and Your Portfolio
As Aristotle famously said, “To know thyself is the beginning of wisdom.” It’s also the way investors can overcome the weaknesses that cause them to make bad decisions, as well as to hone the strengths that allow them to make good decisions.
Traditional economic models expect consumers and investors to behave rationally, but this is hardly the case. We rely on our gut and our intuition to make decisions far more than we’re able to admit—and these gut decisions come down to our biases, the first category of factors that influence our decision-making ability.
The first bias-based factor is overconfidence. To be too optimistic or confident about how one’s portfolio is performing or perhaps what is happening in the broader markets can cause us to become careless and take unreasonable risks. On the other hand, someone who understands that they have the tendency to be too optimistic is already on their way to acting rationally, rather than letting this feeling make the call for them.
The second bias-based factor is representativeness, which is reflected in the adage “past performance does not guarantee future results.” A representativeness bias can cause us to jump to firm conclusions based on limited information by relying on stereotypes instead of due deliberation. A typical example is investing in a stock just based on the expectation that a recent price or earnings performance will continue.
The third bias-based factor is anchoring: We end up relying on just one, often irrelevant, piece of initial information to make a decision, failing to adjust to new information. For example, we are anchored when we base our selling decision on the purchase price without taking into account other current factors.
The next category of factors is based on behavior. When it comes to investing, our behavior is driven by our tolerance for risk and our future orientation. Just as someone who is more inclined to take risks will likely make different investment decisions than someone who is more risk-averse, someone with a greater future orientation will approach the decisions pertaining to their portfolio quite differently.
Remarkably, some people are inclined to make decisions without due consideration to the investment time frames required for an investment to pan out. Similarly, many investors have portfolios that are much riskier than what they are able to tolerate; when the risk level of their portfolio matches them as an investor, they are far less likely to reach for the panic button when things get rocky.
The last two decision-making factors are based on blind spots. In investing, our blind spots are related to the way we perceive our personal level of financial mastery and how well we understand the situation that’s in front of us. Oftentimes, due to the overconfidence bias, people don’t know quite as much as they think they do. Whether that means they have a less-than-stellar grasp of finance, or perhaps a lack of awareness of what’s actually going on in the markets (and how to respond), the consequences can be debilitating.
Every person in the world, to varying degrees, is driven to make decisions based on these factors. The good news is that if we are aware of which factors are most likely to drive our decision-making, we are far less likely to find ourselves the victims of our own bad decisions. The only problem is that it’s hard for most people to self-assess which of the factors they are most sensitive to.
The Power Decisions
Perhaps, as many financial commentators are imploring, we have in fact just entered into the first true bear market since 2008. On the other hand, maybe the latest unemployment figures, compounded with the Fed’s indication that it will take a cautious approach to interest rate hikes in 2019, are a sign that things will start moving higher again. Or maybe wild daily or weekly swings in the markets will become the norm.
No matter which reality plays out, investors and wealth advisors will always have control over how they assess the information in front of them and how they respond to the conditions of the markets. Even better news is that our decision-making ability is something we can always sharpen. By understanding the factors that influence the decisions we make, we are far less likely to make choices that hurt us in the long run.
Prasad Ramani is the founder and chief executive officer of Syntoniq, a financial services company providing tools to financial advisors that bring world class behavioral economics to wealth management.