If you have spent any time on social media in the last few months, you have inevitably seen a host of breathless articles opining on how “Coronavirus Will Change XYZ Forever.” While the impact of COVID-19 is undoubtedly dramatic, it is also human nature to fall prey to several behavioral traps when predicting the future.
Understanding this, the impact of COVID-19 on investors’ behavior will be as varied as the situations in which those investors find themselves. Below, we will examine a few common behavioral biases and how they might impact the investment landscape of the future.
If you thought this was going to be a simple article you could read and set aside, you were sadly mistaken. No, this is a more interactive sort of piece. As part of this engagement, I will ask you to give yourself just 10 seconds to memorize the list of words you’ll soon see below. Take 10 seconds (no cheating!), review the words, and then cover the paper (or your screen) and try to recite the words back without looking. Let’s see how you do:
Welcome back, how did you do? If you’re like most people your recall of the list probably went something like, “Enemies, Annual … um, something, something … Blossom, Femur.” You remembered the first and last words in the string, something psychologists call the primacy and recency effect.
This tendency to remember the first and last part of an interaction is not limited to silly parlor tricks and grocery lists, it is a very important part of how we learn and has implications for how we invest. We are unduly impacted by what has happened lately, a reality that will impact all market participants as long as coronavirus and the associated economic havoc remain a current threat.
You may have decades of investment experience, but not all of those years are weighted equally. The more recent the fear, the more skewed the appraisal of risk and reward.
As mentioned above, both recent and early experiences tend to have outsized mindshare when we consider how to make financial decisions. To help make this more vivid, I’d like you to, you guessed it, play along with me once again. Imagine, if you will, that you and your significant other are headed out for a night on the town. You’re looking for a trustworthy sitter for your young child and have asked a close friend to describe two potential child-care professionals for the evening. Your friend gives you the following descriptions, and you must choose one of the two.
— Sitter one:Is described as intelligent, industrious, impulsive, critical, stubborn and envious.
— Sitter two:Is described as envious, stubborn, critical, impulsive, industrious and intelligent.
So, which do you choose? Being the bright person that you are, you may have deciphered that the two lists of adjectives are identical. Odds are though, you had a strong gut reaction the first sitter is more desirable.
This is due to something called the “irrational primacy effect” or the tendency to give greater weight to information that comes earlier in a list or sentence. It turns out what’s true of communication is also true of our lives — the lessons that we learn early in life are some of the most lasting.
The neurological roots of this psychological reality were illustrated powerfully in a study cited in The Behavioral Investor. In an effort to isolate the parts of the brain implicated in making buy, sell and hold decisions, researchers placed participants in two groups with differing market conditions and then mapped their brains using electroencephalogram (EEG) technology. Group One began in a market that showed steady positive growth, and Group Two was placed in a more volatile market. After the participants spent time trading and learning the market, they switched conditions with those in the growth market entering the volatile market and vice versa.
What the researchers observed next was fascinating and surprising: People used different parts of their brains to make future investment decisions based on their early experience with the market.
Those in Group One who had started with an orderly, predictable market organized their brain activity to create rules and search for universally applicable principles of the market. In the words of the researchers, “Decision-making would be supported by comparison of predicted and actual prices, and it would be driven by rule-based reasoning.”
Conversely, those who began in the more chaotic condition utilized entirely separate parts of the brain to cope with the volatility of their market. Since the volatility of the market did not lend itself to the formation of consistent rules, those in Group Two learned to make situational (i.e., by the seat of their pants) decisions, and this improvisational style carried over even to the calmer market. They were effectively scarred by their bad experiences in the market and were never able to fully search for rules and best practices, even when they became more available.
Experience teaches imperfect lessons
For many of life’s activities, it makes sense that early imprinting on the brain should inform future decisions. It is adaptive for a child born into a war-torn country to program himself for constant vigilance from an early age, just as it is sensible for a child from Beverly Hills to learn that she is in no immediate danger. Variables of place and safety are likely to persist, but market conditions are constantly in flux and can lead us to learn the wrong lessons. An investor who begins investing in the age of COVID-19 may arrive at an inappropriately cruel appraisal of the market, whereas one who started in the early 1990s may characterize them as more consistent and profitable than has historically been the case.
For most of us, our experience is indistinguishable from the experience, and comprises the entirety of how we think about and engage with markets. Breaking this causal chain requires us to seek out diverse perspectives and to become market historians, understanding there are a host of possible outcomes and that we are living in one timeline among many. There is something to be learned from experience, true, but it is only one something among many, and learning the right lessons will require us to visit other people, places and times.
This too shall pass
Legendary investor Jeremy Grantham was asked in an interview what he felt investors would learn from the Great Financial Crisis of 2008-2009, to which he replied:
“In the short term, a lot, in the medium term, a little, in the long term, nothing at all. That would be the historical precedent.”
Grantham’s answer is spot-on because it anticipates recency bias and the behavioral tendency to project the current situation into the future indefinitely. Nobel Memorial Prize winner Daniel Kahneman refers to this construct as WYSIATI, or “what you see is all there is.”
When investors look around now, they see sickness, economic uncertainty, widespread joblessness and a variety of inconvenient societal disruptions. While it’s almost certainly true that some vestiges of COVID-19 will be with us for years (strict handwashing, please), it’s likewise true the day will come when we once again gather in large crowds, commute to offices and shake hands.
To think the future will look just like the present moment is to ignore the singular nature of what we are currently experiencing. It’s human nature to assume that all we see is all that will ever be, but markets operate on a more forward-looking basis and realize that “this too shall pass.”
Certain of us will have our investing behavior irrevocably altered either because we were personally impacted by coronavirus or because it impacted us at a formative period in our development. But to become the best investors we can be, we must learn to put probability above stories, and large numbers above personal experience. Most of all, we must learn to hope for a brighter tomorrow, which is fundamentally what investing in the future is all about.
(Article written by Kiplinger)