Investors need to watch out for several biases that can impact their decisions and allocations when navigating tricky markets.
The risk of these behavioural influences has risen given expectations that today’s new regime will see increased volatility.
Blackrock believes these factors warrant careful thought about portfolio changes. “We are guarding against their pitfalls because we believe the new regime requires an overhaul of portfolios,” said Emily Haisley, behavioral finance, Blackrock Risk & Quantitative Analysis.
The global asset manager has reduced portfolio risk throughout 2022. Its latest tactical move is a move up in quality by downgrading developed market stocks and upgrading investment grade credit.
For example, it has underweighted US Treasuries and overweighted inflation-linked bonds, believing markets are underestimating the new regime’s inflationary nature.
Beware bias
However, behavioral biases also need to be considered, given their subconscious influence on investment decisions.
Among the three main ones that Blackrock is concerned about is the disposition effect. This, explained Haisley, is the tendency to hold losing positions too long and sell winning ones too soon, based on evidence that many people feel the pain of loss twice as strongly as they experience an equivalent gain as pleasurable.
“We expect the disposition bias to be most prevalent when investors are feeling stinging losses – like so far this year. Both stocks and bonds have racked up declines not seen since the 1970s,” she added.
A second, dangerous bias for professional investors is inertia. This happens when investors are reluctant to make changes, or when they make changes that are too small to affect performance.
“The era of steady growth and inflation known as the Great Moderation is over, we believe,” said Haisley. “Yet central banks appear to believe they can magically curb inflation and cause only a mild economic slowdown. We see more volatility ahead as markets have rallied on hopes the Fed is about to change course and relax policy.”
Blackrock believes that such dynamics call for investors to change their portfolios more quickly.
“It will be costly, in our view, to just follow playbooks such as ‘buying the dip’ or make slow and minimal changes,” Haisley added.
A third bias to guard against in the current market backdrop is endowment, where investors tend to overvalue their assets. This is based on having owned them for a long time and therefore thinking they should get a higher price to sell them.
In practice, investors might hold on to positions even after an investment strategy has played out.
“This can hurt performance,” said Haisley. “Positions often produce more returns earlier in their life spans, we find.”
Protecting portfolios
To mitigate behavioural biases, Blackrock suggests investors consider that they are starting from a blank canvas. They can then construct what they believe is the ideal portfolio for the most likely market and macro environment over their time horizon.
While this doesn’t mean abandoning long-standing investment processes, it enables portfolio changes without basing them on historical holdings and performance.
Investors should also consider future market events or performance thresholds that would signal when to take profit or cut losses.
“Making a plan can help determine how to react amid volatile markets and high emotions,” added Haisley.
