Quarterly Perspectives

Q3

, 2022

Managing Market Emotions and Biases

“Be fearful when others are greedy,
and greedy when others are fearful”
-Warren Buffett

Warren Buffett’s contrarian investment philosophy likely resonates with many who embrace a value-oriented mindset. While there is inherent logic in this time-tested recommendation, adhering to advice of this nature presents practical challenges. Sticking with an asset allocation strategy and rebalancing into risk assets during downturns is often the right approach, although doing so can be easier said than done.

The past three years have offered yet another stress test in our ability to deal with volatility. Those who sold under duress in early 2020, or later chased highly speculative momentum plays, risked compromising long-term returns. Volatility has clearly returned in the face of high inflation, rapidly tightening monetary policy, Russia’s invasion of Ukraine, and a very shaky global economic outlook. In this environment, helping clients avoid overly emotional reactions to turbulence is not easy, although gaining emotional insight can reduce the likelihood of doing the wrong thing at the wrong time.

The Roots of Investor Psychology
At their core, markets are a function of fundamentals and psychology.  Last year we wrote about communication, understanding risk tolerance, and generational and experiential distinctions that influence investors. Let’s now focus on the difference between emotional biases and cognitive biases, as this may be useful in recognizing potential influences on one’s investment mindset.

Emotional biases involve basing decisions on individual perceptions and feelings that may cloud judgment. A few common ones include:

  • Herding – crowd following, or buying what is popular without fundamentally based reasons;
  • Loss aversion – a strong reluctance to acknowledge a mistake by realizing a loss;
  • Overconfidence – excessive belief in one’s expertise in a given area;
  • Endowment bias – overvaluing what you are familiar with.

Recognizing the extent to which you may be susceptible to various emotional pitfalls does not eliminate their influence, although considering these factors in dialogue with your portfolio manager can lead to better long-term decisions.

Cognitive biases involve decision-making based on preconceived notions that may not be accurate, such as:

  • Anchoring – focusing on a reference point such as what you paid for a stock rather than what it may actually be worth;
  • Recency bias – excessive attention paid to the most recent information received regardless of its relevance;
  • Confirmation bias – seeking out information that suggests one is correct in an opinion and overlooking contradictory information;
  • Small sample fallacy – drawing conclusions from potentially insignificant data points.

Cognitive biases can shade the perspective of both portfolio managers and individuals making their own investment decisions. Here too, mitigating their potentially harmful impact demands first recognizing our underlying thought process.

Step Back to Gain Broader Perspective

Warren Buffett has long advised investors to think of common stock shares as pieces of businesses to own over the long term, not as objects to be traded. At Appleton, our equity research process evaluates stocks with this in mind and looks at factors such as sustainability of a business model as well as valuation rather than focusing on tactical trading. We seek to mitigate analyst biases in part by bringing stock recommendations to the Equity Investment Committee before names are approved.

Self-awareness is a valuable trait, and we admit to not having unique market timing expertise. Instead, our equity investment process relies on proprietary research to minimize the influence of emotion or overly short-term thinking. We look for opportunities to purchase or add to stocks our team likes on a fundamental basis when the market gives us an ability to do so at attractive prices. Capital markets history has long demonstrated that a company’s market price tends to fluctuate much more rapidly than its business prospects. In essence, short-term perceptions are usually more volatile than long-term business value, a dynamic that speaks to the need to stay grounded during challenging periods while also not abandoning risk constraints during speculative times.

Most importantly, each client’s asset allocation plan serves as a foundation around which investment strategy is developed and employed. Unless there is a compelling reason to adjust course, staying with a well-designed, risk-managed plan is a good way to reduce the risk of emotions and biases clouding investment judgement. In fact, it may come as a surprise that half of the S&P 500’s best days over the last 20 years have come during bear markets.

A Personalized Approach

When working with clients on investment strategy, our Portfolio Managers first attempt to set expectations. In our experience, goals-based planning makes investment strategy more tangible and less susceptible to emotion. Communication is also essential, which is why we emphasize collaborative, accessible client service.

Like any other aspect of psychology, individual responses to market stress differ considerably and some investors struggle with turbulent markets more than others. “Tuning out the noise” is a challenge for many, but one that we feel can be mitigated by better understanding your investment psychology, falling back on a disciplined, risk-based asset allocation plan, and working closely with your Portfolio Manager. We’re here to help in any environment, so please do not hesitate to reach out with questions or concerns.

This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.  Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal.
Q4
"The recent passing of legendary investor Charlie Munger has prompted many prominent investors to publicly reflect upon his wisdom. The human element was often central to Munger’s insights concerning investment decision-making, and he was a pioneer in the field of behavioral finance."
Q3
“Traffic is an inevitable part of urban American life as those of us who frequent highways in Greater Boston or most other metropolitan areas know all too well. Apologies for raising an irritating topic, but we feel there are useful parallels to be drawn between driving and investment decision-making.”
Q2
“Atisa Dipamkara, a revered 11th century Buddhist philosopher, once said, “The greatest wisdom is seeing through appearances.” His insight into looking beyond first impressions resonates in today’s investment world. While diversification has long been touted as a means of mitigating risk, we recognize that it is far from solely determined by the number of securities held in an index or portfolio.”