Oct. 30, 2020
Here’s an election prediction you can take to the bank: Whenever the count is over and no matter who wins the presidency, tens of millions of people are going to be elated and millions of others are going to be despondent.
But regardless of the emotion driving them, people acting in the heat of the moment may make decisions about their personal finances that prove costly.
While those decisions often seem irrational in hindsight, they’re completely predictable to people who study behavioral finance, the branch of economics that aims to understand how emotions affect financial choices. In many circles, it has supplanted the traditional economic view that people are rational actors who look to maximize gain and minimize loss. Instead, behavioral finance concedes that most people are prone to being fallible and foolish.
For Americans grappling with a pandemic, social unrest and electoral uncertainty, this year has been a petri dish of anxiety, angst and decisions based on fear or folly. Practitioners of behavioral finance have had a field day examining the responses.
“From the new day trader up to endowment and hedge fund managers, we’re all subject to these biases that don’t change,” said Emmett Maguire III, director of manager search and selection at Boston Private, a wealth management firm. “There’s a physiological and a psychological hard wiring that we can’t override.”
Dan Egan, director of behavioral finance Betterment, put it another way. “We don’t have well-organized compartments in our brain for how we feel about circumstances,” he said. “We often get strong emotional leakage from one side to another. We’re mad at a child and we end up snapping at a co-worker.”
That behavioral bias, Mr. Egan said, is “getting worse with the election.” He added, “People are thinking, ‘If my side wins, it’s going to go well and be great for the economy, and if the other side wins, it’s going to be horrible.’”
(Regardless of which side you’re on, he noted, it’s not likely to be as good or as bad as you imagine.)
Here is a look at some behavioral finance biases that have affected people’s decision-making this year and others that are likely to crop up around the election. The good news is that there are ways to minimize their impact, at least on your financial decisions.
What you’ve been feeling: If you were feeling deeply pessimistic about your investments in the spring, even after the market rallied, you were exhibiting signs of what the behavioral economists call “extrapolation bias.” But guess what. If you decided to become a day trader in April when the stock market rebounded, and you’re thrilled with the gains you’ve made, you are under the same effect now.
Extrapolation bias occurs when people give added weight to current events in the belief that those events will continue. Stefano Giglio, a professor of finance at the Yale School of Management, conducted surveys of investors as the pandemic began. In February, as the coronavirus was just beginning its spread in the United States, investors expected a 6 percent return this year for the S&P 500. By mid-March, investors were expecting just a 1 percent return, and that expectation stayed there through April — even though stocks had begun to rebound.
“People across the board became more pessimistic,” Professor Giglio said.
Yet new investors who had little experience in investing have found themselves performing like hedge fund stars if they started investing in the spring, Mr. Maguire, of Boston Private, said. Since late March, stocks have generally gone up, although they’ve been more choppy recently. But if those investors think their returns are the result of immense skill and not a bit of good market timing, they could suffer mightily in a market correction.
“I fully intend people to keep doing this, but it could end badly for them,” Mr. Maguire said. “It’s a change in behavior that’s explained by the anticipation of gains, which triggers a dopamine response in the brain.”
Another contributor to anxiety about investing is the availability bias, which means the more you see information repeated, the more you think that information will be true in the long term — without examining other potential outcomes.
With the pandemic, many people could not help but draw lessons from them previous pandemics, said Michael Liersch, head of advice and planning for Wells Fargo’s wealth and investment management division. But, he said, that kind of thinking doesn’t work in the long run, even if it makes us feel better in the moment.
How the election will make you feel: The stress of the election, regardless of which candidate you support, is likely to raise even more of the behavioral biases that people have been feeling during the pandemic.
One is the disjunction effect, in which people want information to be revealed before they make a decision, even if they would make that same decision with or without that information. Knowing the election results is an example. Even if there is a clear victor next week, there are still a lot of unknowns about the incoming administration that might affect investments.
“What will be implemented?” Mr. Liersch said. “Is there tax reform? What will change, and what won’t change? When we’re in this moment, when we don’t know the outcomes, a lot of people can’t continue to engage.”
But that’s the moment when you should engage, Mr. Liersch said. In other words, who wins the presidential election or which party controls Congress are just parts of a bigger puzzle that investors need to consider.
For example, if someone’s preferred candidate doesn’t win, Mr. Egan said, that person might look to sell whole chunks of his portfolio — to detrimental effect.
“What we were hearing now from clients is more about anxiety and people saying, ‘We want to wait until things are certain,’” Mr. Egan said. “What we’re telling people is: ‘You’d need the candidates to have radically different policies to cause harm. And there isn’t that big of a difference between candidates that would have short-term impacts on the stock market.’”
What you can do about it: You are subject to these behavioral biases because of the hard wiring in your brain. But how best to manage them?
“What we know is these behavioral biases are accentuated in periods of stress,” said Scott Clemons, chief investment strategist at the wealth management advisory firm Brown Brothers Harriman. “That alone heightens the risk of giving into that subconscious knee-jerk reaction.”
He said he was already seeing hindsight bias in clients. “It’s the thinking that everyone knew the market was going to bounce back, that that was inevitable,” he said. “But it wasn’t inevitable in April. We were all staring into a black hole.”
So how do you combat these hard-wired biases?
Start with going back to your financial plan and analyzing how a sudden drop in your portfolio’s value might affect you next year or 10 years from now. Then, in an anxious moment, write down what you’re thinking and feeling. This will be valuable to return to later, when chances are your worst fears did not come to pass.
Mr. Clemons is pushing clients to record their feelings now, he said, so that however things are in the new year, they have something to look back on during future bouts of anxiety.
“In the new year, everyone will say they knew a Biden or a Trump victory is good for markets, or it was bad for the markets,” he said. “But no one knows anything right now.”
In a survey from Betterment released on Wednesday, more than three-quarters of respondents said in September that they didn’t intend to make an investment change after the election.
Doing nothing is fine if that was part of your original plan. But be aware that it is as much a choice as buying or selling. One way to approach any stressful moment is to seek out contrary opinions before making any decision. This will help with what’s known as familiarity bias — the tendency to seek out things we know in times of uncertainty. That could lead to investing in companies that have their headquarters near where we live or in a company where a friend works. Or it could mean focusing on things we see, like local real estate.
“That can create risks in someone’s portfolio,” Mr. Liersch said. “Who knows what could happen in one area? We need to diversify across the country and the globe.”
Most important, though, people who are stressed out next week need to look beyond the current moment. It also wouldn’t hurt to have some extra cash on hand just in case your hard-wired biases take hold and you consider doing something you may later regret.
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