By George M. Smith
If the market volatility of 2018 has gotten your attention, you are not alone. What we are experiencing is historically normal, but for many it doesn’t feel that way. For many investors, times like these may generate memories of past personal market experiences or others’ stories – some positive, but probably mostly negative – and you may feel compelled to react, or at least assess the situation to determine if any decision is necessary. This is normal, and there is a term for it. It is called a heuristic.
A heuristic can be defined as a learning aid, or an approach to discovery or problem-solving that serves to make decisions or conclusions easier or faster. Inherent in heuristics is impracticality since a (decision-making) process routinely involves emotions, incomplete facts, and/or biases. In short, the purpose of such a process is to come up with an acceptable answer, guess, result or conclusion, for now.
More specifically, an availability heuristic is a process supported by what an individual can quickly and easily recall. It has been labeled a “shortcut” for decision making or evaluation. With the availability heuristic it is presumed that the “important or relevant things” are easier to remember, or perhaps they are at least more important or relevant only because of what a person can remember versus other potential solutions that aren’t readily remembered, or even known.
This is significant because it is all too common for investors to apply past experiences or vicarious experiences to what is happening in today’s market or economy. Basically, the more the negative news ramps up and the scary predictions are promulgated, along with more persistent and frequent market swings, people inevitably recall 2008. For example, in the first two months of 2016, when the market was down, I remember asking clients when they thought the last time the market was down this much and the overwhelming answer was 2008. Even though the decline was only about 11%, which wasn’t even close to 2008, it felt that way for some. If you reacted to the 2016 market swing, or the current one, based on what happened in 2008 then you probably applied some form of heuristics.
While the research on heuristics is valuable, has been on-going for decades, and plays a role in daily life, should it really impact financial decisions? It is no surprise that markets fluctuate and have since market metrics have been tracked. In fact, the following chart shows that there are dips every single year, even in the years that end with positive performance. The average intra-year drop for 1979 through 2017 is about 14%.
US Market Intra-Year Gains and Declines vs. Calendar Year Returns, 1979–2017
In US dollars. US Market is measured by the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
Clearly this isn’t some new phenomena. So why the psychology lesson? Financial decisions are often made with an improper perspective or incomplete data, so it is important to identify potential pitfalls of decision-making for the purpose of empowering oneself to make better choices. It’s akin to correcting blurry vision by putting on a pair of glasses.
In 2008, for those who had to change their retirement plans or delay other goals, was it the market or poor planning to blame? Since we know that markets and economies unpredictably fluctuate, (sometimes severely) doesn’t it seem logical that effort should be made beforehand to address what will likely happen? Isn’t that why we have spare tires, insurance coverage and alarm-systems?
Forward progress in life towards goals will necessarily require various forms of risk to be taken. If you are unaware of or ignore these risks it is at your peril and you are basically relying on luck. Those who properly planned to retire in 2008 still retired, and most are likely still comfortably retired today. They developed a plan, they regularly tested that plan and executed that plan. They experienced the same scary news and the same drastic market swings as everybody else, but they had confidence.
What steps have you taken to address the unpredictable? Do you have a plan at all? If so, are you confident in your plans? Are you relying on yourself or some financial product to get you through, or are you seeking the help of a qualified and objective professional to guide you to and through an important stage of life? If you are seeking help, ask how many people that person has helped transition into retirement. Ask them to verify that they are acting as a fiduciary. Ask them to disclose their conflicts of interest and how they get paid.
Take control of your life and make a good plan, or perhaps you should seek a second opinion on plans you have now. Otherwise you may find yourself reacting to recalled past fears, influenced by media “noise” or potentially be sold a product that sounds good but isn’t what you need. If you are looking to make future decisions don’t rely on what you can easily remember but seek to understand all you need to know for a more secure future.