The 6 behavioral finance lessons of 2021

6 behavioral finance lessons of 2021

December 31, 2021 10:38 AM

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The big theme of investing for 2021 has been decision-making under uncertainty. When things are unpredictable or unreliable, cognitive and emotional biases can play an even bigger role in investors’ decisions. As Morgan Stanley wrote in an Aug. 2020 note, the pandemic has served as a trigger for emotional biases of many stripes.

While COVID wreaked havoc on the economy and personal and professional lives, it had a strange bedfellow: a housing market on fire and a stock market that performed extraordinarily well. Although the S&P 500 ended Dec. 30 up more than 29% for the year, it underwent jolting dips as skittish investors reacted to the delta and omicron variants and to President Joe Biden’s early tax proposal last April to nearly double the long-term capital gains rate. The combination of it all has been a jolt to the investing psyche.

Behavioral finance is the branch of economics and psychology that deals with the effects of cognitive errors and emotional biases on investors, both retail and institutional, and financial markets. Here are six behavioral finance lessons of 2021 for financial advisors and their clients:

Check your politics at the investing door

Former Vice President Joe Biden, 2020 Democratic presidential candidate, speaks during a news conference in Wilmington, Delaware, U.S., on Thursday, March 12, 2020. Biden sought to deliver an antidote to President Donald Trump's response to the coronavirus outbreak on Thursday, unveiling a new plan that shows how he would fight the spread of the virus and urging the administration to use it. Photographer: Ryan Collerd/Bloomberg

Academic research shows that individuals become more optimistic about the stock market and the economy when their preferred political party is in power. That means they’re willing to take on more risk in their retirement portfolios. But “if left unchecked, this bias can lead investors to assume market risk that is not necessarily aligned with their risk tolerance,” according to a widely read

paper

in the Journal of Financial Markets from scholars at the University of Colorado-Denver, University of Miami and Brigham Young University in 2017.

“Investing based on your politics is crazy,”

wrote

Martin Tillier, a contributor to Nasdaq’s blog, on Dec. 28. “Those that sold when Trump was elected got hurt, as did those who sold in anticipation of a Biden-led attack on capitalism. Understand that we all have biases, accept them, and put them aside when investing.”

Advisors are constantly nudging clients to make sure that their portfolios reflect their appetite for risk.

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Be aware of your FOMO

Many “meme stocks” — shares in companies with passionate followers on social media — exploded in value, with GameStop and AMC Entertainment carrying the torch as retail investors and day traders stampeded to Reddit’s WallStreetBets forum and online brokerage Robinhood. AMC shares began the year at around $2 a pop, then spiked to more than $62 in June, a whopping 1,250% gain. It closed the year at around half that level. Investors who bought early are doing well, but those who followed the crowd for fear of missing out after June’s spike are not.

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Confront your present bias

Present bias refers to the tendency of people to lend more value to immediate or near-term payoffs than to those further down the road. The deprivations of the pandemic and quarantine prompted some investors to say

YOLO

(“you only live once”) and ditch their jobs, start new businesses or get off the corporate track altogether. While that’s fine for those with hefty retirement cushions already in place, those with less saved up may be trading the future for the present.

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Recognize that irrationality is unbounded

A core tenet of behavioral finance, a field pioneered by economist Richard Thaler, economist and psychologist Daniel Kahneman and psychologist Amos Tversky, is that investors aren’t rational.

Phillip Toews, the CEO of Toews Asset Management in New York, argued in an email that 2021 showed that “from meme stocks priced at infinity times earnings to cryptocurrencies with no intrinsic value valued at $3 trillion, we learned that even the largest institutions can be tempted once the crowd's momentum accelerates. This matters even for investors with conventional portfolios. When worthless assets become a large enough part of the financial system they create instability, not unlike a building that has weak beams that threaten the whole structure. “

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Conduct a “premortem”

The pandemic has brought the issue of mortality to the fore. While it’s never pretty or pleasant to think about death, doing so can be useful for retirement planning. Gary Klein, a cognitive psychologist, pioneered a “

premortem

” method of strategizing and planning, in which an individual imagines the range of possible outcomes years down the road for a project, whether it’s a company’s transformation or an investment strategy. The exercise is conducted as if looking back from the future to the present and is undertaken before any decisions are actually made. The point: to surface obstacles and poor moves before they actually appear. Michael Mauboussin, the head of consilient research at Morgan Stanley’s Counterpoint Global investment fund, advocates for the technique in his co-authored book, Expectations Investing, revised and updated in October 2021.

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Balance financial and mental health

Toews said that the pandemic has given investors a chance to look deep inside themselves and figure out who they really are and what they really want in life. Investors should “try to align one’s investing with who they really are,” he wrote. “If they truly are a massive risk-taker and OK with plummeting losses and skyrocketing peaks in the same year, then fine, but almost no one is really like that. Take a moment to try and imagine what that would feel like. Most people are just looking for a comfortable retirement and not an emotional ride.”

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