Are We Really Due for a Correction?

Prognostication is a favorite investor pastime.  It affects, whether consciously or not, just about every market participant, from retail investor to market strategist. We always have some viewpoint about the future of the markets. While it can be frustrating, it is completely normal. The brain is a planning machine and therefore will always project what the future may hold. What we want to do is make sure our clients think about all information when drawing conclusions (not what they just happen to read).

But We are Reverting to the Mean

“We are due” is commonly thought and said among investors. That statement, while it may feel completely rational, is heavily influenced by unconscious biases. For instance, the brain is using the recency bias to make future opinions based on most recent outcomes. Couple that with our skewed understanding of reversion to the mean, and it becomes a very powerful and persuasive viewpoint.

Investors erroneously define reversion to the mean as if the opposite is going to happen…an easy mental shortcut. A simple example: if markets return an average of 9% per year, and last year the market was up 24% we would need to experience a negative return to average these two years out to 9%. Incorrect logic, but seems to make sense. Then comes the next idea, “Why invest in a stock market that is going to be negative when money markets are paying 5%?”

At this point, the confirmation bias takes hold as the investor seeks information that supports their viewpoint while ignoring any contradictory information. If they expect poor market performance they will likely say something about how ugly politics are (and we will have a divisive election), how richly valued the market is, and that nothing goes up forever. All of those are true statements, but it doesn’t consider all information. It’s essential to consider all relevant information when making wise decisions.

Combatting Misperceptions

Investors suffer from many misperceptions – thanks to innate biases and the effect of the financial media. It is essential that you address the misperceptions and correct them, without upsetting or making a client feel bad. How do you do that? Here are a few steps that can be very helpful:

  1. Validate their concerns. This puts you on the same side of the table. And it reinforces an important truth – there will always be something to worry about. Wall Street climbs a wall of worry; significant wealth has been made by investors who acknowledge the “worry of the day” but didn’t allow it to influence their investment strategy.
  2. Share your experience of times when “this has to happen” didn’t end up happening. When you share personal experiences, you are in a powerful position to indirectly invite clients to learn from you. One example is the certain recession of 2022 (then of 2023) than never came to pass. Surprised just about everyone!
  3. Play devil’s advocate – and tell them you are going to play that part, just to make sure you consider all information. For instance, you could share that 2023 was the first year when the market was up over 20% and investors were net sellers of stocks. Last year the money went to money markets because of their yield. That means there is a lot of cash on the sidelines.

As we seek to improve the investor experience (which is more than just financial gain), having real conversations with clients about their concerns and views of the future can be very helpful And don’t be afraid to share your experience and coach them to consider more productive and correct perceptions – in fact that is one of the greatest values of financial advisors today!

– JAY

(c)2024 Behavioral Finance Network