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How to beat cognitive errors after Covid

July 15, 2021

reading time: 10 minutes

by Thomas Cooper, guest author

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The Covid pandemic has given scientists more insights into the behavioral mistakes investors make during financial crises and bubbles and how to avoid them.

From February to April 2020, fears about the impact of Covid sparked the fastest market falls for over a century. But fear was short-lived, and the subsequent recovery was also one of the quickest and strongest in history as investors chased rising prices to their current overvalued state

As reported in MagNet last year, an astonishing picture is emerging about the costly role of human errors in investing. These mistakes are perilous during crashes and bubbles, when herd mentality plays a strong role.

Nobel prize-winning academics such as Richard Thaler and Daniel Kahneman have shown that deeply-ingrained behavioral biases - such as fear, greed, and overconfidence – drive most people’s investment decisions. These errors cost the average investor between 1% and 4% a year in returns, and much more during a sharp collapse or rebound.

But disciplined investors can use these errors to their advantage. 

How investor errors played out during Covid

The cause of last year’s crash was different to recent crises such as the tech crash of 1999 to 2002 and credit crunch of 2008 and 2009. Investors’ initial panic was typical of recent crashes, though the subsequent recovery and euphoria since April 2020 has been unusually swift.

Hersh Shefrin, professor of finance at Santa Clara University in California, said very few investors bother to assess fundamental stock values as reflected in companies’ cash flows and profits. Consequently, market prices become a function of investor sentiment rather than of fundamentals.

So when bad news hits the headlines, herd fear and panic kick in quickly, leading to mass sell-offs and irrational overreactions.

Thomas Wille, head of research and strategy at LGT, said: ‘It always seems to follow the same pattern. Last year, panicked investors sold shares as if the world was going under and the Dow and S&P stock indices were set to virtually sink to zero. But then people realized that, while Covid is a significant threat with short-term uncertainty, it won’t go on forever.’

Noting the very high level of trading over that time, Wille said another common error investors make is to think they can make money by timing the market from such a situation.

‘They need to remember that, as economist John Maynard Keynes said, “markets can stay irrational for longer than you can stay solvent.” That means stocks can stay over- or under-valued longer than the average investor can afford to bet against it. So, often it is better to move yourself to the sidelines and watch on. At LGT, we did not believe the world would break apart because it usually doesn't. We were surprised at how fast markets recovered, but that was due to central banks pumping trillions of dollars into markets.’

Dopamine bubbles

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Dopamin is part of the problem (Shutterstock)

Since then, euphoric investors made the opposite mistake and chased up stock prices too high, leading to the current lofty valuations compared to fundamentals.

Shefrin said we now know from research that market bubbles generate dopamine highs for investors, and these highs support the persistence of overvaluation.

‘Overvaluation bias is a consistent pattern, and dopamine appears to be a big part of the explanation, just as it is a big part of the opioid crisis,’ says Shefrin. ‘For most investors, the biggest mistake is to get caught in that wild ride, holding undiversified portfolios, and not rebalancing through short-term volatility.’

Exerting this kind of discipline is a challenge for most investors, though. To maintain it, Shefrin recommends using a coach, such as a financial planner who has no conflict of interest with their clients. Or you could join an investment club whose members are motivated by a long-term performance rather than short-term entertainment or ‘getting rich quick’.

Higher stakes

Another question raised by the pandemic is whether investors are becoming more vulnerable to their own mistakes. In other words, are the stakes getting higher?

Some experts argue that globalization has led to increased risks to undisciplined investors. They argue volatility has become more exaggerated, and investors are especially vulnerable to rare or unprecedented events such as the 2008 financial crisis and the pandemic.

Global travel links mean an adverse event in China or America can lead to increasingly fast and exaggerated ripple effects around the globe. Meanwhile the increasing popularity of online trading means more amateur investors are making online trades, which can exacerbate volatility.

These issues make it even more important to stay disciplined and avoid cognitive errors.

‘All these facets of markets grab investors' attention and distract them from the healthy habits associated with long-term investment results,’ says Shefrin. ‘It's just that healthy investment behavior is more boring than its thrill-seeking counterparts, and our minds are wired to respond to excitement. That's why we check our mobile phones for messages so often.’

Stay well diversified

With equities once again at high valuations, investors face a particularly tough challenge. LGT analyses show expected returns on equities are likely to be below average in the next few years, and to stay at their lowest level in years.

Wille says, previously, there was an alternative to equities available in such situations in the form of good yields on government bonds – for example, when US Treasuries were at 6% in 2000. Today that option is not available due to interest rates being very low or negative in many countries.

‘To avoid errors, it is therefore more important than ever to define and understand your long-term strategy and stick to it,’ he says. ‘Investors now have to be extremely disciplined. Understand what you own, why, and what is the price tag.

‘Look carefully at what compensation you are likely to receive for the risks you take. For example, several companies have great management and potential profits ahead, but they have insane price tags — don’t touch them.’

According to Wille, using actively managed, well-diversified funds are a good way to avoid mistakes, with an increased focus on selection these days.

‘That's why you should always look under the hood and understand what's inside each fund,’ he said. ‘Then you should stick with those funds for the long term, or set clear limits on when you want to take profits or limit losses, and stick to those limits. In this environment, the support of experienced portfolio managers and active fund managers is a valuable component.’.

Photocredit: Coverpicture Shutterstock

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