We’re kicking off the new year with many consumer products in short supply; however, predictions about the stock market and the economy are plentiful. With uncertainty surrounding interest rates, supply chains and inflation, the economic disruptions of the past two years have left us wondering whether markets will ever return to “normal.” One thing remains unchanged: markets and the economy are unpredictable. Despite investors’ worst fears during the past two years, the S&P 500 index has gained 119.84%, increasing from a low of 2,191.86 on March 23, 2020, and reaching a new high of 4,818.62 on January 4, 2022. Investors are left wondering what 2022 will bring.
The greatest predictor of an investor’s long-term rate of return is not the ability to accurately predict the timing of supply chain fluctuations, inflation impacts or interest rate movements. It’s whether investors can understand and correct their own irrational behaviors and biases. There have been many scientific contributions to the emerging field of behavioral finance over the years. We learn through empirical evidence that the human mind is one of the greatest obstacles to improving investors’ decisions and capturing long-term market returns. The brain has two ways to process information and make decisions, but investors often use the wrong system to make important investment decisions.
In the 1970s, Amos Tversky and Daniel Kahneman challenged the idea that humans are rational decision makers. Their research pointed out that the first of the two decision methods used by humans is a fast-thinking system full of mental shortcuts. We need this system to survive. When our ancestors heard the bushes ru stle, they didn’t consider the very high probability that it was caused by the wind versus the deadly possibility that it was a lion.
When our bushes rustle, our desire for immediate certainty overrides any thought of considering the probability of all possible outcomes. Instinctively, we know that the deadly result of not running at the rare chance a lion is in the bushes outweighs the harmless result of running when the rustling bushes are just the wind.
The second decision method is a slow-thinking system analyzing all possibilities. This type of thinking requires significantly more mental resources than the first system.
Investors use the mental shortcuts and approximations of system one to make investment decisions. Many of the biases and mental shortcuts our brains use attempt to deal with uncertainty in the same way our ancestors deal with the rustling noises in the bushes. A very common investor bias is aversion to loss. Emotionally, the pain of loss far outweighs the enjoyment of an equivalent gain. This decision shortcut can lead to selling an investment during steep price declines for fear of losing investment gains.
System two teaches us a more rational approach to the same decision of whether to hold or sell. Steep price declines will occur multiple times in a long-term investment. Although significant drops in the value of an investment are scary, they should be expected and incorporated into a long-term investment plan. There is no free lunch. Investors desiring to capture market returns must be willing to hold long-term diversified stock investments during steep price declines. Investors must expect and plan for price declines along the path to capturing long-term market returns.
The illusion of certainty convinces investors to believe that the results of their decisions are certain and that chance does not influence their investment results. This decision shortcut can seduce an investor into attempting to time investment buys and sells based on the predicted price movements of the stock market. Investors may believe the results will be certain because they got it right last time, or the so-called “expert” got it right last time.
System two thinking teaches that both investors’ decisions and chance play a role in investments’ outcome. Investors are forced to make decisions about an uncertain future and should consider the probability of potential investment outcomes. Equity investments are a volatile asset class in the short run, yet produce superior returns in the long run. Buying and holding stock for more than five years has a much higher probability of success than attempting to outguess the market using short-term market timing strategies.
When raw emotions start to dominate your investment decisions, remember to take a step back and remove yourself from the moment. Our emotions are the most volatile when we are thinking only of the moment, but when we consider the long view, our emotions stabilize. We make better decisions. We shift out of system one and into system two.
Remember, we crave certainty when faced with the emotional rollercoaster of an unknown future. The problem with this tendency is that certainty in an uncertain world is an illusion. Mental shortcuts to relieve the emotions of uncertainty often result in poor decisions.
As we look to 2022 and beyond, the greatest impact on our long-term investment returns won’t be the short-term economic ailments worrying investors. It will be the investor’s ability to move their investment decisions from the emotions of system one to the rational, long-term approach of system two. We would all do well to understand the following reasonings in our approach to investment decisions:
• Avoid making important investment decisions when emotions are high.
• Avoid investm ent strategies based on extreme outcomes.
• Consider the probability of investment outcomes.
• Commit today to future investment decisions based on sound empirical evidence.
• Commit to long-term investment strategies that match your investment time horizon.
Investors who develop these behaviors and reduce investment risk through appropriate portfolio diversification and asset allocation can expect to significantly increase their long-term investment returns.
Aaron B. Sautter is a financial advisor with Onyx Financial Advisors, LLC, an independent, fee-only registered investment advisor firm in Idaho Falls, Idaho. He can be reached at (208) 522–6400 or at www.OnyxFinancial.com.