Investor psychology is an important aspect of trading. Understanding human emotions and their corresponding actions can give us a leg up in improving our trading and capitalizing on the mistakes and foibles of others. Volatile markets show this play out in real-time as panic ensues and massive moves are forgotten weeks later. The beginning of March 2025 might be another example of knee-jerk reactions resulting in poor decision-making. What can you do to avoid these traps?
Current Market Situation
As of the March 10th close, the S&P is down 7.25% for the month. This level would make it the worst returning month since September 2022. The so-called fear gauge VIX is up 100% in less than a month. Reasons include tariffs, geo-political upheaval, and uncertainty brought about by new US policies under the Trump administration. Canadian and Mexican duties hit especially hard, and front-running to avoid these expenses hurt first-quarter GDP.
Like always, perspective is warranted. This is the fifth time since January 2022 that we went through a 7.25% loss or greater period. The majority occurred during the 2022 rate hiking cycle, culminating in a 19.44% loss for that year. We can now view that as a minor blip in the run since 2019 that includes double-digit returns every year outside of that one. Even with this current loss, we just returned to September 2024 numbers. One can always argue that this time is different, and it might be, but the rules of investing still apply. Buy low and sell high. Easier said than done.
Common Investor Biases
We talk to many investors and see recurring themes of both popular and our own observed biases. The traditional list includes the following:
- Confirmation Bias – Seeking information that agrees with your viewpoint while discounting alternative information that does not fit your idea. This leaks into political opinions as well.
- Loss aversion – We tend to remember losing money more than making gains. This often results in selling investments that are going up too quickly and holding a falling position for too long, which we believe will recover.
- Overconfidence Bias – Amateur traders often think they are better than they are only to painfully find out that they need to learn more. Experienced managers fall into the same trap.
- Anchoring Bias – Holding on to your original thesis even though the situation changed.
- Herding Bias – Often described as mania or fear of missing out (FOMO). This results in concentrated trades where the growing crowd is pushing a trade higher. The reversals tend to be brutal as the same crowd rushes to the exits. We see this one occur over and over throughout time from the Dutch Tulip Mania in the 1600s to the tech bubble of the 2000s.
- Recency bias – This applies to the current market, focusing on just this month’s losses while ignoring the historical context. In the same way, previous periods of extreme losses are forgotten quickly.
- Availability Bias – We use our memory to determine the likelihood of events happening. Our recollection is often poor though. This causes us to discount the possibility of scenarios. Black Swan events occur rarely, but they happen more often than we expect. Just listen to the news stories about “Once-in-a-lifetime” events that seem to occur weekly.
Additional Biases
- Comparison bias – It is easy to find examples of investments that did better than yours. We tend to view this as a loss even if our returns were positive. This leads to chasing better performance and often failing. It is much easier to invest in hindsight. Ideally, we would identify our own goals, create a plan, and stick with it long-term.
- Greed bias – Potentially the most dangerous of them all. Discounting information or objective risks because the upside looks so attractive. This is what Bernie Madoff used to his advantage as investors flocked to his funds without even a cursory understanding of what he was doing. This also caused them to over-allocate and ignore diversification.
Trump’s Second-Term Policies Impacting Markets
The second Trump term is in its beginning stages. Opinions vary on the purpose of some of his actions but several themes seem to be recurring. One is encouraging manufacturers back to the United States from overseas, as well as Canada and Mexico. He is using tariffs on incoming goods and matching foreign levies they apply to US products to motivate this change. The second is pushing the Fed to reduce rates. As a real estate developer, he understands refinancing. The United States spent so much over the past decade that a slowing economy and better rate environment could save trillions in interest payments on the Federal debt. Lastly, government spending and hiring drove many of the gains over the past 5 years. Removing this stimulus will be painful, but a lame-duck President with experience in the position might be the person to get finances under control. He cannot run again so legacy and success are the only motivating factors.
Investment Strategy Takeaways
We can make better choices as investors if we can moderate our behavior with our biases in mind. Building a diversified portfolio for all market environments, that fits our goals and risk tolerances, and can be comfortably held through multiple economic cycles is the best long-term process. Consistent re-evaluation of our assumptions makes sense, but the best time to make decisions is with sober reflection during calm periods. The current volatility is consistent with historical moves in equity markets. Hopefully, you are benefitting from the bias traps ensnaring less sophisticated investors.
Actionable Steps
If you want to add an absolute return manager to help diversify your portfolio, please call or email your IASG representative. We can find you a complementary piece for your asset allocation strategy.