The Great Depression, the ’73 oil crisis, the dot-com crash, and the ’08 financial crisis – all of these moments made their mark in history, particularly when it comes to market volatility. Although each crisis had its unique differences, they each brought about similar investor behaviour. But why is that? Despite these historical events showing us that every downturn is followed by a period of recovery, why do many investors cash out during periods of market turbulence, locking in losses, missing opportunities with the recovery while ignoring sound advice?
The science of behavioural economics can help explain this decision-making pattern and may help investors make better decisions during the COVID-19 pandemic.
The COVID-19 outbreak is different than any crisis experienced before. The market volatility observed in March 2020 caused the S&P 500 to fall 30 per cent from its record high in just 22 days, making it the fastest drop of this size in history. From a behavioural perspective, predictable, irrational behaviour was observed as the pandemic resulted in record outflows from the Canadian mutual fund industry to the tune of over $15 billion in the month of March alone. This panic selling is consistent with market downturns of the past.
According to behavioural economics principles, investors make irrational decisions during volatile markets because of the basic nature of their neurophysiology. All humans have two modes of decision-making: one is relatively effortless and intuitive and the other takes effort and is highly rational. Time constraints, lack of knowledge and energy, the influence of emotions, and panic can make people more biased during periods of market volatility. As a result, they'll make less-than-ideal decisions. This premise is the foundation of behavioural economics.
Emotional and irrational decisions
Long before the COVID-19 pandemic, Manulife Investment Management took the initiative to include behavioural economics as part of its support for advisors, to help them better prepare investors to navigate market volatility. In 2018, we partnered with BEworks, a commercial consulting team dedicated to applying behavioural economics in real-world challenges. The goal was to provide training, seminars, and resources for mastering the scientific study of human behaviour as a powerful tool to better understand consumers and to counteract sub-optimal investment decision-making.
How can investors and advisors identify biases before they make decisions that may be detrimental in the long run? Although there are hundreds of biases to study through the lens of behavioural economics, here are four common ones observed in investor behaviour during recent months:
- Illusion of control bias: This common bias occurs when investors think they have control over a powerless situation and feel a need to regain control by taking unnecessary action. Irrational actions will give a sense of control when that’s simply impossible. Anxiety, panic, and loss of control become dominant emotions and it becomes almost impossible to stick to the plan.
- Representative bias: Investors may believe that current financial performance represents future performance. This bias is mostly present when an investor is sensitive to headline information. When representative bias is present, investors may think recent returns reflect future returns despite evidence to the contrary. Negative emotions commonly increase when representative bias is present.
- Loss aversion bias: People feel the pain of a loss more acutely than the pleasure of an equivalent gain. For this reason, it’s common for investors to, for example, leave money in a savings account that’s earning less than the rate of inflation. During market volatility, loss-averse investors are often willing to assume a risk to avoid a potential loss but unwilling to assume a risk to capture an equivalent potential gain.
- Overconfidence bias: In an unstable market, investors can believe that they are more knowledgeable or capable than they actually are. Reality, however, is just the opposite. A 2018 study found that 55.4 per cent1 of those investors who considered themselves investment experts scored below average when their investment expertise was put to the test.
Investors are usually unaware of their biases and how they affect their financial well-being. Working with an advisor who understands the science behind behaviour can help investors step back and observe objectively. Then, working together, investors and advisors can find solutions and create a roadmap toward long-term wealth goals.
Navigating market volatility
Understanding the biases that explain investor behaviour is the first step towards helping curb clients’ irrational decisions. In times of crisis, it’s common for investors to dismiss their advisor’s counsel because of the emotions attached to their decisions. If that occurs, advisors can tap into different behavioural techniques and strategies to steer their clients towards sound investment decisions, which could have profound impacts on their overall financial plan.
A recent study by BEworks2 and Manulife Investment Management found that 84 per cent of participants said they had an advisor. More interestingly, respondents who had a financial advisor varied significantly in the extent to which they followed financial advice, with only 15 per cent stating they let their advisor make all the decisions. This statistic confirms the importance of measuring not only whether investors have an advisor, but also whether people follow the advice given when trying to determine the value of advice. Furthermore, the results of the study also show that behavioural economics increases how well people follow professional financial advice and enhances the benefits of doing so.
During a crisis, the role of an advisor evolves. Oftentimes, it’s not the portfolio that needs assistance, rather, it’s the investor. It becomes even more important for advisors to have open and empathetic conversations with their clients to make sure they maintain a trusting partnership. Using the following behavioural economics techniques in these conversations could be the key to overcoming potentially poor decisions:
- Easy-to-remember rules: Going by mental rules of thumb allows investors to better remember and retrieve information during a market downturn. The rules must be simple, involve inaction, and be easy to remember – such as “When prices go down, the opportunity to profit usually goes up” or “Everything in the market just went on sale; let’s go bargain-hunting for some long-term value.”
- Loss framing and long-term framing: Framing foregone gains as a loss allows advisors to help their clients ride out short-term market declines. For example, selling an investment at $90 that subsequently rises to $110 is effectively the same as losing $20. Additionally, encouraging clients to look at their portfolio performance less often or in its entirety reduces the anxiety and poor decisions they might make if they look at their investments daily.
- Information accessibility: When investors seem affected by overconfidence bias, it could be helpful to give them a small nudge by asking them to name a few market timers from among well-known stock market experts. Clients are likely to draw a complete blank and are likely to reconsider a bad decision. When people lack knowledge of a topic, they tend to believe information that’s easier to retrieve. The harder it is to think of supporting reasons, the less convincing the initial argument.
Even if an advisor has mastered and applied all the mentioned behavioural economics techniques, feelings of anxiety and panic can still sometimes take over for investors during stressful situations. Equipping advisors with tools and resources to achieve the best possible outcome during times of uncertainty helps them deal with clients in trying times. Applying the principles of behavioural economics not only reinforces the value of financial advice but also helps to protect the livelihoods of Canadians and their investment goals. In the future, you shouldn’t have to wait for a downturn to react. In this case, the best defense will be a strong offense.
1 Lewis, D. R. (2018). The perils of overconfidence: Why many consumers fail to seek advice when they really should. Journal of Financial Services Marketing, 23(2), 104-111. doi: 10.1057/s41264-018-0048-7 2 2020 Value of behaviourally informed advice, BEWorks, Manulife Investment Management 2020.
A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.
Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
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