Check Your Biases

It has been only a few weeks since the “Liberation Day” announcement sent markets reeling.  We are now at a moment of relative calm before… what?  More volatility?  Or a new America First bull market run?  Only time will tell.  But what investors expect will happen is a different story.  Investor views on what comes next are grounded in their overall worldview.  From my discussions these past few weeks, it is evident how investors’ outlooks seem dominated by factors like political affiliation and regard for the current president. 

This backdrop of perspectives based on worldview seems more acute now than I’ve ever seen before.  People reacted to the Liberation Day tumult in terms of fear and hope, and only rarely with a sense of thoughtfulness and reason.  Throughout this episode, I saw people dig into their viewpoint and see what they expected to see as the news unfolded.  It struck me how susceptible we all are to our own errors in thinking, our cognitive biases. 

In light of this, now might be as good a time as any to think about cognitive biases and how we each have errors in thinking which can cloud our understanding of what’s going on.  Cognitive biases are common – we all have them.  Left unmanaged, biases can lead to bad decision making.  If we are at a brief lull in the drama of the markets (at least for stocks), let’s take a moment to review cognitive biases and how they can mislead us. 

Cognitive Biases
When considering cognitive biases, I ask you to consider your own biases and errors of decision making.  It does no good to only think about how wrongheaded everyone else is.  How are you making poor evaluations of the world around you?  How might this negatively influence your decisions as an investor?

Common Types of Cognitive Biases
There are many types of biases, each with its own impact.  Biases can be about how we process changing circumstances, how we take in new information, how we are impacted by the news and noise around us, and so on.  Below are three of the many cognitive biases that commonly appeared during my conversations during the tumult of recent weeks:

Confirmation Bias:  This occurs when an investor seeks information that confirms their pre-existing beliefs or opinions and disregards or avoids any input or evidence that might contradict their viewpoint.  For example, a bearish investor might feel certain we are living on borrowed time before the big market collapse finally consumes us.  This investor might see negative news reports as confirmation of the coming storm when in fact the risks are real but not existential.  Exaggerating risks could cause the investor to allocate very conservatively and miss out on larger (but more volatile) gains.

Ingroup or Partisan Bias:  This happens when investors favor the leadership and policies that align with their own political affiliation to the extent that they assume markets will thrive when their preferred party is in power and will decline when their opponents are in control.  For example, I came across investors in 2023 who were convinced that the economy under Joe Biden would soon collapse, in spite of fundamental and market evidence to the contrary.  As a result, they didn’t invest in stocks during this time and missed a strong rally.

Availability or Recency Bias:  This is when investors make decisions based on readily available information or recent events, rather than considering all the relevant data.  For example, dramatic news headlines can impact an investor’s opinions and even cause them to seek changes to their portfolio.  This would be wrongheaded if headlines highlight surface issues, while ignoring or deemphasizing positive underlying fundamental trends.

Conclusion
Cognitive biases are natural and common.  We may be very good at identifying them in others, less so in diagnosing ourselves.  But markets do not care about your opinions and biases; they will do what they are going to do.  For investors, the challenge is to look within yourself and try to define what are your own potential cognitive biases.  Then consider how these might lead you astray.  For my own part, I have a bias toward optimism.  You might attribute this to my relative earned and unearned societal privilege.  I have to be careful not to impose my sense of optimism on my analyses and expectations.  I have to be open to the potential for negative outcomes. 

In all, I think things move forward in a messy, noisy, but ultimately positive trend – not for everyone but for most.  There are regrettable and sad outcomes, but for the majority, over the long term, the trend has been upward and I think this will continue.  During these current days of high emotion and volatility, investors more than ever need to be careful, dispassionate, and deliberate in our analyses.  This might be an unwelcome approach for more activist-oriented conversations.  But for investors, it is critical.

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There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.  The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.