Behavioral Bias Lessons

Behavioral Bias Lessons

The volatility in the pandemic-era equity markets have given a rare glimpse into specific behavioral biases that usually aren’t as apparent during “normal” times, contends an opinion piece in CFAInstitute by Binod Shankar.

These biases include:

Stepping back too soon: many investors shied away from the market after the first pandemic plunge and didn’t buy quality companies with long track records of solid balance sheets that were bound to recover, such as cruise lines. Several factors held investors back, the article maintains, such as the tendency to focus too much on short-term losses and ignore the potential for gains in the long term (known as “Myopic Loss Aversion”). “Continuation Bias,” where investors believe that the volatility will continue indefinitely and “Regret Aversion,” when investors don’t want to experience any buyer’s remorse if the purchase doesn’t work out, were other behavioral biases that kept investors on the sidelines.

Pursuing pandemic winners even when they became losers: fueled by federal stimulus and the shift to work-from-home, many stocks became huge winners practically overnight. But that growth became unsustainable as revenue and demand was pulled back. Still, many investors just couldn’t let go, and the article points to three major biases that played into this, such as “Self-Enhancing Bias,” which is the belief that choosing a stock whose price skyrocketed indicates brilliance on the part of the investor, rather than just luck and a market pumped full of cheap money. “Herd Behavior”—going along with the crowd—and “Confirmation Bias”—surrounding yourself with voices that only validate your choices instead of questioning them—also played a role.

Missing the inflation clues: very few people expected inflation to surge so high and stick around for so long, and “Availability Bias” likely played a role here, which “comes down to the three Rs: We recall what’s recent and consider it relevant.” Because inflation hasn’t moved much in 10 years, most assumed that it likely never would.

Following the meme stock craze: another example of herd behavior at work, “Framing Bias” was also likely at play here, where investors were making choices based on how information was being “framed” to them, instead of solid fact. The retail investors versus institutional firms was an attractive narrative to many, including those who had never invested before.

Adhering too closely to the “buy low and sell high” approach: many stocks dropped during the pandemic, and investors were quick to gobble them up—even though most of these stocks were still priced much higher than valuations justified. This was likely because of “Anchoring Bias,” with investors focused too much on the earlier, overvalued high price and thinking they were getting a bargain even though they really weren’t.

Putting too much trust in the Fed: everyone, from Jerome Powell on down, said that inflation would be transitory. But Powell and the Fed were sorely mistaken, and the likelihood of them navigating a “soft landing” is getting slimmer by the day—especially considering that the central bank has only engineered a “perfect soft landing” once in the last 11 tightening periods. “Authority Bias” was definitely at play here, with too much trust placed in “the experts” or “formal authorities.” Gender and race biases can also factor into Authority Bias.

“[T]he more we eliminate biases from our investment process, the better our investment returns,” writes Shankar in the article’s conclusion. Investors memories are often too short, but perhaps by keeping these bias-driven mistakes in mind—no matter how painful it may be—will keep us from repeating the same errors in the future.