Regular readers know that I expect the economy to slip into recession within the next 12 months. This is based on the expert analysis of veteran economists whom I trust. However, I’ve been thinking this for the last two years, and been proven wrong. It’s a reminder that none of us knows as much as we think we do.
Whether I’m right about the timing or not, we will have another recession sooner or later. A recession is defined as two consecutive quarters of negative Gross Domestic Product growth. Stock markets tend to anticipate the economy, so by the time the economy pulls back the stock market will already be down sharply. I’m expecting a 40 percent steep but brief pullback. I’m also confident that the markets will recover pretty quickly and move forward to new highs.
A market pullback can be a very challenging time for investors, mostly because of human nature. Below are five wealth-destroying habits that are likely to emerge during a market downturn. I hope a bit of insight will help you manage and overcome these challenges to your financial health.
Heuristics are mental shortcuts humans take to save time making decisions. They are not great decision-making methods, but they are powerful, instinctive habits deeply entrenched in human nature.
- Anchoring. Establishing a point of reference that rightly or wrongly influences financial decision-making. For example, my accounts had a total value of $500,000 in August of 2018. Any value below that feels like a “loss” regardless of what my initial investment was.
- Availability bias. The tendency to overrate the likelihood of events that are easy to recall. If they come to mind easily, then they must be accurate. For example, I remember ACME stock fell by 20 percent last year then bounced back three weeks later to a new high.
Prospect theory shows that for most humans, losses hurt twice as much as gains feel good. A couple examples:
- In an experiment, students where told they had just won $30.
- One group was offered a coin flip where they would either win or lose $9. (They would either end up with $21 or $39.) Seventy percent of students took the coin toss.
- A second group was also offered a coin flip. They were told their total winnings would either be $21 or $39. (Same result options as group one.) Only 43 percent of these students took the coin flip.
In both groups, the net result was the same to the students. The conclusion was that in the first group, they viewed the coin flip as “bonus money” and were more willing to take a risk. The second group saw the coin flip as “risking their winnings” and they wanted to avoid the risk.
- Most people would rather win $500 and stop as opposed to winning $1,500 and then losing $1,000. (Same net proceeds in either case.) This natural tendency is an important part of understanding your tolerance for the fluctuation in value of your investments.
Framing bias. People favor options based on the way information is presented. They favor the option with the positive spin. For example, most people prefer a half-full scenario versus a half-empty one, even though they’re the same.
Extrapolation bias is the tendency to become overly focused on current trends and to believe that they will continue or accelerate. For example, if markets hit an all-time high for the tenth year in a row, people think the market will keep going up for a long time.)
Planning fallacy is the tendency to underestimate the amount of time and money we need to successfully achieve objectives, including long-term financial goals. This is specific to our estimation of our own ability to reach a goal. It’s an unfounded optimism about how efficient we will be. An interesting counter point is that generally when we look at other’s plans for a goal, our instinct is to be pessimistic about them. For example, people may think they don’t have much saved now, but they can save enough to retire over the next 10 years.
One thing is clear to me as we review these biases: Human nature is sneaky. These instinctive, natural choices really feel right. But they can wreck your financial prospects.
This is a reminder of the value of having a trained, experienced, professional engaged to advise you in your process of setting goals and working to achieve them. A great way to find a professional to help you in planning your financial life is to look for a CERTIFIED FINANCIAL PLANNER™ professional.
To find a CFP® professional near you, start your search here.
As you visit with financial planners, I suggest a couple things to check:
- Is the advisor always the client’s advocate – a fiduciary advisor?
- Is the advisor only paid by clients, not any financial product manufacturer or distribution network? That would be a fee-only advisor.
These two points help assure that you are working with a professional who is committed to your best interest at all times. It seems sort of obvious to me that a professional would work in this way, but it’s not automatic.
A fiduciary, fee-only, CFP® professional can help you make great financial planning choices and develop a comprehensive financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.
Yes, I am a CFP® professional. I’m always a fiduciary and I only work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office at firstname.lastname@example.org. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.