Don’t be Short Sighted

Written by: Martin X. Shields

To be financially successful, it is important to understand how much our financial and investment decisions are impacted by our personal behavioral characteristics and our emotions versus solid analytical research. Having a good understanding of this interdependence doesn’t mean that you will be able to completely remove emotions or human biases from financial decisions, but it will allow you to be aware of how they can skew your financial decisions, often in a negative fashion.

 
A common bias that many investors tend to have is “recency bias” where our investment views are influenced by what we experienced most recently in the markets. One common occurrence of this bias is when an asset class has performed well over the short term, investors tend to want to add to that allocation. The flip side to this is when an asset class is underperforming, investors tend to want to sell out. Frequently, these decisions are made at the absolute wrong time, typically when an asset class is hitting an all-time high or an all-time low.

It is in these situations where investors tend to forget about their long-term plan and the long-term performance of an asset class and tend to focus entirely on the short-term performance of an asset class.
In this discussion it is important to remember that there may be times when based on solid analytical research you may want to overweight a strong performing asset class because the data points to the possibility of the momentum continue. The same can be said for underweighting a poor performing asset class. The problem with most investors is that they tend to make these decisions based on emotions and not research or they tend to make the changes in a dramatic fashion (i.e. going all to cash or holding highly concentrated positions).
The best way to limit the impact of the bias is to develop a well thought out investment strategy and stick with it for the long-term. If you decide to deviate from the investment plan make sure the change is based on solid data and analysis and not a gut feeling.