The first half of the year has come and gone, nothing marks the middle of summer like the 4th of July. Even if it did fall on a Tuesday this year. The depiction of the 4th that resonates most with me is the scene in The Sandlot where the kids play their one night game of the year because the fireworks are bright enough to light up the sky. All the while, Ray Charles is singing “America the Beautiful” in the background. Hands down the best version of the song. It’s a much-needed day of unity.
It's tough to see the US so divided politically and now, we are seeing a complete divide in where economists see the market going from here. Strategist forecasts depict the widest gap between the highest and lowest S&P 500 targets in the last 20 years. The consensus 2nd half 2023 target is a drop of negative -6%.
Strategists post biggest gap between the highest and lowest targets
Their S&P 500 target points to most bearish second-half outlook on record
With the increase in uncertainty and the dispersion of expert opinions, we are seeing a real surge in behavioral biases amongst an investor base that is prone to them in the first place. Behavioral finance is fascinating. It’s the study of psychological influences on investors and financial markets. The stock market doesn’t move in predictable and rational ways and that’s because investor behavior is imperfect, and human beings succumb to these patterns constantly. We see manifestations of behavioral biases just about every day in our interactions with clients. In fact, I would say a large part of our job is identifying, untangling and correcting them in constructive ways that avoid derailing plans.
The good news is you can reduce the impact they have on you.
Investing is so emotional, and on top of it, individuals tend to believe their approach is best. They don’t have the self-awareness or experience to know that we all have hard-wired behaviors hurting our long-term best interest. This extends to all walks of life.
With that being said, let’s take a break from our regularly scheduled programming and introduce behavioral finance and some of the popular biases we frequently see on display.
A bias can be either a cognitive, which involves faulty reasoning or emotional which is based on feelings. We all fall victim to many of these biases and as soon as you see them, I’m sure they’ll resonate.
One of the classics is Overconfidence. Like Apollo Creed in Rocky II or the Russians in the 1980 Miracle on Ice, overconfidence can lead to defeat. We constantly hear folks say that they are great investors, and their own performance has been superior. I think a lot of this confidence comes from the fact that from 12/31/2008 to 12/31/2021, 13 years, the S&P 500 was up 16% per year and the Technology Sector was up over 22%. Whatever you invested in went up and the riskier it was, the better. It made the common investor feel like a superstar. The economy is different now, we have inflation at 4.1%, the Fed Funds rate is 5.25% and earnings have been struggling. If you lack experience or analytical training you could easily face defeat if you’re over confident. The sad thing is that defeat, in this case, could look like missing out on your dream retirement.
In a similar lens, in 2022 when the market was down -18%, investors who took credit for their great performance during the prior 13-years then blamed the market or Biden or their financial advisor once they saw their investments slide in 2022. They were demonstrating Self-Attribution Bias. It’s like an athlete taking responsibility for a win but blaming a loss on his teammates or the coaches.
A primary catalyst for the sudden surge in the Nasdaq and S&P is the Artificial Intelligence Boom. This momentum is a market anomaly, and this Herd Mentality is when investors pile into a trade and cause this return pattern. May as well be called FOMO or Bandwagon Bias. We’ve seen this time and time again. Think of the hysteria with crypto, AMC and NFTs. There’s even a movie coming out called “Dumb Money” about the GameStop fiasco. My barometer for whether or not there’s herd mentality in the market is when my mother starts asking questions like, “Frankie, what’s a non-fungible token?”
There are some stocks that are up over 100% on the year, like Nvidia. It’s common to fall in love with a position because it made you a lot of money or maybe you’ve owned it for so long that you’ve become emotionally attached and then it becomes difficult to part ways. Well, if you value an investment more highly than if it never belonged to you at all, that’s the Endowment Effect. This is so common with homeowners when they are unwilling to sell their house at a fair market value. They’ve become attached and feel as though it’s worth more than they would have if they’d never owned it.
This market environment could get frustrating for advisors who attempt to solve financial problems for individuals, but the individual decides to do nothing instead. If someone feels an investment is too complex and they don’t understand it, they could become fearful of a negative outcome, and refuse any changes no matter what argument is raised. This is the Status Quo Bias. People sometimes prefer to keep things the way they are even when they are much better off making a change. Options, derivatives, and alternatives can be great investments in this market but if you're fearful of a negative outcome you become your own worst enemy.
Understanding behavioral finance and learning about biases help with self-awareness and may save you from making mistakes. Simply keeping an open mind and having the patience to learn can help tremendously. If you emphasize ideas or news that confirms your beliefs but disregard or put less weight on ideas that are contradictory, you suffer from Confirmation Bias. If an investor only believes in passive index funds, they may ignore research or data that argues that direct indexing could be much better because of the tax efficiencies and customizability.
My favorite part of behavioral finance is how relatable and common these biases are. If the bias is emotional, it becomes a lot more challenging to resolve but if it’s cognitive a little education could fix the problem. Hopefully, one of the beauties of working with financial advisors is navigating through these challenges. The solution to many of the aforementioned, could involve a combination of diversification, a financial plan and professional advice.
This information is provided for informational purposes only and does not contain investment advice or an offer or recommendation of securities. Connectus Wealth, LLC d/b/a Connectus Private is an SEC registered investment adviser. Investment does not imply government endorsement or that the adviser has attained a level of skill or training.