The COVID-19 pandemic has caused significant turbulence in global capital marketsCapital markets Where people buy and sell investments.+ read full definition. As a result, many investors have experienced dramatic deceases in the value of their investment portfolios. How investors respond to such losses can be critical for keeping on track with their long-term investing goals. It is not always clear what the best course of action is at a time like this but there are several insights from behavioural science that can help investors think more clearly about the decisions that they are facing.
1. Loss Aversion
Individuals do not feel gains and losses equally. We psychologically experience losses twice as strongly as gains. Put simply, losing $100 hurts more than gaining $100 feels good. Even if our portfolios recover to their pre-crisis levels, the pain of the losses can make investors feel like they are worse off.
2. Risk Seeking
People are more willing to take risks to avoid losses than to make gains. After experiencing a drop in portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition value, the desire to recoup losses can cause people become more willing to take risks. This risk-seeking behaviour may cause individuals to pursue investment opportunities that are not aligned with their long-term goals.
Occurs when investors focus too much on the present and not enough on the bigger picture. This is especially common when investors are focusing on a specific investment instead of considering their entire portfolio. Receiving information about investment performance too frequently can cause myopia and lead investors to adopt strategies that are not aligned with their investment plans.
Information is one of the primary drivers of myopia, but not all information receives equal attention from investors. The more easily information comes to mind, the more available it is to be used in decision making. The 24-hour news cycle and social media can lead to investors overweighing certain information in their decisions. This can lead to herd behaviour, market bubbles and other undesirable investing behaviours.
5. Sunk Cost Fallacy
This occurs when a person allows costs that cannot be recovered, such as time or money, to influence their decisions. When a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition price decreases, investors may purchase more of the stock at the lower price in hopes that an increase will enable them to recover money that they lost with their initial investment. This is an example of the sunk cost fallacy. The decision to invest at the lower price should not be influenced by a previous investment. If the price continues to decline, investors can end up multiplying their losses by “throwing good money after bad.”
The overconfidence effect occurs when someone perceives their abilities to be greater than they actually are. This is a frequent problem for investors. Capital markets have historically rebounded from sudden decreases or crashes. As prices drop, many investors try to determine when the market will reach its lowest point so that they can buy more assets just before prices begin to recover. Even professional investment firms struggle to do this when faced with significant market turmoil and uncertainty. Overconfidence bias can lead many investors to believe that they can “time the market” even though only a small fraction will be lucky enough to do it.
7. Regret Aversion
When dealing with uncertain decisions, people often anticipate how much regret they will feel if they are wrong. This anticipated regret can have large effects on people’s decision making. One way that people tend to minimize regret is by doing what others are doing instead of using their own information to make the best decision for themselves.
During the COVID-19 pandemic, all seven of these aspects of human behaviour can become more pronounced in our decision making as investors. Knowing about them does not eliminate them. Investors will still experience the psychological and emotional effects of loss aversion, risk seeking, myopia, availability, the sunk cost fallacy, overconfidence and regret aversion. Understanding these biases and how they impact decision making can help investors think more clearly about the decisions they have to make about their financial futures.