by Daniel Yu, CFA®, AIF®, REDW Stanley Financial Advisors
A recent headline read that the Dow Jones Industrial average posted its first eight quarter win in 20 years. It is rare to go two years straight without a negative quarter, and the question on many minds has been, “When will the equity markets experience a correction?†A correction is often defined as decline of 10 to 20%. Trying to predict the next decline is notoriously hard (some might say a fool’s errand), and back in April we discussed four economic areas that affect the velocity of money (see our April newsletter, Policies and Investing).
There have been no significant changes in monetary policy, taxation, regulation, or trade, and therefore the backdrop for continued growth has not changed. However, with the long streak of continuous gains in equities, it is natural to become nervous. So, we will build on our last newsletter, Investor Behaviors and Investment Basics, where we discussed some general investor behaviors.
In economics, loss aversion is the tendency of people to hurt more from a loss than to feel good from a gain. In other words, if your $500,000 portfolio declines to $450,000 (a 10% loss), it hurts more than the positive feeling of when your portfolio increases to $550,000 (a 10% gain). In more severe cases of loss aversion, a person can experience an “amygdala hijack†(a term coined by Daniel Goleman).
During an amygdala hijack, one’s emotional responses overwhelm the rational thought process. In the case of an investor, losses become so severe that the emotional center takes over and our actions become irrational. However, “severe†is a relative term for each person and changes over time for each person, due to factors that may have little or nothing to do with financial matters. This is why regular communication with your Relationship Manager is so very important. Part of the value your Relationship Manager brings is to help you navigate the facts and feelings of your situation so as to avoid an amygdala hijack.
Another issue affecting how we feel about financial information is called confirmation bias. Confirmation bias is the tendency to seek out and interpret information that confirms a person’s pre-existing belief or hypothesis. Confirmation bias tends to be even stronger the more emotionally involved a person becomes. It is easy to let the recent positive gains in the equity markets reinforce a vague impression of “something has to give†or “waiting for the other shoe to drop.â€
However, as investors, we at REDW Stanley work to keep ourselves from allowing confirmation bias from influencing our interpretation of the data. That is why we look at a broad swath of information and develop a macro-economic picture using many data points instead of just one or two. Overall the data indicates ongoing economic growth. It does not mean that in any given shorter time frame we will not see declines; but we cannot support the idea of recession.
The old adage is true, “Knowledge is power.†By understanding the existence of loss aversion and confirmation bias, the professionals at REDW Stanley can work to mitigate their effects and maintain a disciplined investment approach designed to meet your financial goals. Please contact your Relationship Manager if you have further questions or issues you want to discuss.
Copyright 2017 REDW Stanley Financial Advisors, LLC. All Rights Reserved. This publication is intended for general informational purposes only and should not be construed as investment, financial, tax, or legal advice.
