Picture this, you’re having a conversation with your parents while opening the refrigerator door. You extend your hand towards the half-eaten chocolate and in a moment of suddenness, it seems you’ve already done this before. But you can’t seem to remember when. That, my friend, is déjà vu.
Picture another scenario. Say you’re reading the newspaper this time and the S&P index has dipped more than the usual. You think you’ve been here before, except this time, you exactly remember when: 2008. Your memory is bitter about the experience because the last time it happened, it didn’t bode well.
The 2008 Debacle
Anyone with a rough idea of the 2008 housing bubble would know that it wasn’t pretty. To quote Moody’s, “The stock market plummeted, wiping out nearly $8 trillion in value between late 2007 and 2009. Unemployment climbed, peaking at 10 percent in October 2009. Americans lost $9.8 trillion in wealth”.
However, just like the human mood, changes in the stock market come in waves. Where there is a low, there is a high. Thus, it’s no wonder that the stock market made a comeback: the home prices rebounded and the employment rate ticked upward. But unfortunately, the story doesn’t end here. Here’s the catch: the market may forget, but the human cannot.
Stocks have more than doubled since the financial crisis, and yet, a lot of investors have remarkably tweaked down their equity exposure. (For some context, equity is that part of your investment portfolio which leans towards risk. The same is compensated by the possibility of higher returns). Sounds weird, right?
“The vast majority of people have some equity holdings in their 401(k) plans”, said Brian Reid, Chief Economist at the Investment Company Institute (ICI), but fewer are willing to take above-average or substantial risk than they were in 2008 before the market plummeted.
A recent Cogent Research report found that risk aversion among all age groups has been on the rise since 2006, including Generation X and Y, who have lived through a number of market collapses. To simplify, investors have become more risk-averse since the 2008 financial crisis. But why?
The Déjà Vu
Apparently, the ramifications of a financial crisis are more profound than we think: they perpetuate biases. The underlying bias observed here is called ‘Experiential Bias’. This occurs when investors' memory of recent events makes them biased or leads them to believe that an event is far more likely to occur again. This culminates in a lot of investors permanently quitting the market or overestimating the impending hardships in a market.
Facing the Music
Warren Buffet once said, “Our favourite holding period is forever”. According to him, the secret recipe to minting clever money is holding on to stocks, even when their price collapses, for the simple reason that they will bounce back up, over time. But what happens to the investors who left the market at the end of 2008 or early 2009? It wouldn’t take big brains to figure out that they paid a high price.
On a personal level, quitting the market midway deprives investors of the opportunity of recovering their losses during the recoil. Moreover, reluctance to invest in risky avenues strips you of the prospects of earning fancy rewards. On a larger level, this may also contribute to negative consumer sentiment. Let us see how.
If every second investor hurt by the 2008 crisis exits the stock market, and consciously or subconsciously propels fellow investors to quit too, won’t economic transactions and activity tumble? Sounds unlikely, right? Why would I succumb to and base my decisions on borrowed apprehensions, instead of my own independent analysis? Enter ‘Herd Bias’, yet another fragment of behavioural finance. We’re hard-wired to herd and imitate what other investors are doing. Contrary to traditional beliefs, investors are not invariably rational, they have limits to their self-control and are prone to falling ill to their own biases and fallacies.
Let’s say that the aggrieved investor doesn’t quit the market but instead reads every non-average (but normal) dip in S&P or Dow Jones as the onset of something critical. Consequently and gradually, the investor might begin to disinvest (the move is motivated by a fallacy, but is disinvestment nevertheless). If there are sufficient people believing this idea, it is enough to drive the market down. Note that financial markets are driven by popular beliefs, not logical beliefs.
Too far-fetched, right? It is. But replicate this on a large scale, and voila, you have investor sentiment tipping a slowdown. Those who are still firmly gripped by the ravages of the crisis, have lost all appetite for risk and thus, shirk any and every opportunity that knocks on their doors. They focus on the preservation of capital, not its growth. Sadly though, escapism isn’t the key. Turns out, a no-risk portfolio leaves you financially unprepared.
Breaking the Bias
While there might be some empiricism and truth driving such behaviour, one must actively try not to fall prey to his/her own biases. Here is some advice to help you steer through the horrors of the past (and life, generally) and take decisions objectively:
Be Reflective: There are two approaches to arriving at investment decisions: Reflexive and Reflective. While the former is the default, automatic gut response to situations, the latter is the logical and methodical one. Even though the reflective approach demands efforts and research, it assists in making informed choices. So step back, dwell over the situation from a bird’s eye view, and then decide.
Let Bygones be Bygones: Don’t anchor everything in the present to the traumatic events in your past. If it has happened once, don’t be so sure it will happen again. Learn from your mistakes and let the rest go.
Most News is Noise: Don’t believe everything you read and don’t shoehorn every market dip into your past trauma.
Don’t Indulge in Peer Pressure: To quote Warren Buffet once again, “The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd”. You do you!
To sum up, ‘Experiential Bias’ is natural. It’s like holding the umbrella when the rains have ceased. You don’t want to let go of it just yet, because it takes more than just time to shake the trauma out. But you know you’ll have to because it’s going to block the sunlight that comes your way.
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