Behavioral Finance 101 (Part 2)

Key Points

  • Irrational behavior, although common, can degrade investment returns over time.
  • In order to invest wisely, it’s important to understand where investors often get tripped up.
  • Recency Bias is the notion that we often overemphasize recent events over longer-term averages when making decisions about uncertain future events.

Stormy Weather

Having lived in Florida for a few years, I have had the not-very-distinct pleasure of encountering two hurricanes during my time in the state; Hurricane Matthew in 2016 and Hurricane Irma in 2017. Both were Category 5 storms on the Saffir–Simpson scale (read: really big) and both caused massive damage (over $15 billion for Matthew and over $64 billion for Irma) and unfortunately many fatalities as well (603 for Matthew and 134 for Irma).

Storms are classified by the strength of their sustained winds, and according to the Saffir-Simpson scale, the Category 5 is the highest classification, with sustained winds in excess of 156 miles per hour. According to the National Hurricane Center (NHC), for Category 5 storms, “Catastrophic damage will occur: A high percentage of framed homes will be destroyed, with total roof failure and wall collapse. Fallen trees and power poles will isolate residential areas. Power outages will last for weeks to possibly months. Most of the area will be uninhabitable for weeks or months.”

My wife and I left town for Matthew, as advised. We weren’t so fortunate for Irma. My wife went into labor just as the storm was beginning to attract attention in the news, and my daughter had the perhaps-more-distinct pleasure of being born a few days before Irma hit land. Having been released from the hospital the night before Irma landed, my newly-enhanced family spent the majority of the storm huddled in our tiny downstairs half-bathroom, as the massive hurricane, with its accompanying tornados ripped through our city.

But ultimately, we were very fortunate. The storm tore through our town leaving a path of destruction that was, as the NHC would predict, savage. But my family sustained no issues, and the final damage to our home was minimal. The only tree in our backyard fell down, but it missed our home by a few feet (did I say we were very lucky?). However, almost the entire state was impacted by this tragic natural disaster.

More than 7.7 million homes and businesses in Florida were left without electricity at some point – approximately 73.33% of state.[175][176]

When it came time to renew my homeowner’s insurance policy soon after hurricane season had ended, I had some very important decisions to make. As I was reviewing options on how much coverage I had and how much I thought I would need you can perhaps very easily guess what was on my mind.

Recency Bias

This is the notion that recent events have a greater weighting on our decisions than is rationally warranted. Let’s explore this notion through an analogy, using homeowners insurance as an example.

So what happens to individual’s behavior right after the hurricane hits? You guessed it–people go out and beef up their insurance policies. Imagine that you’ve witnessed a Category 5 tear through your state. Even though your particular house was spared, there’s a far better chance you’ll opt for the lower deductible, or for a wider breadth of coverage once you’ve witnessed such a storm with all its might, including all the non-stop media attention that goes with it.

Now, consider this: did the chances of another hurricane hitting go up just because we just had one hit? Not really, but because it’s a recent event, it’s on individuals minds, and thus, it influences their behavior.

On the flip side, if it’s been a long time since a hurricane has hit, individuals may actually start to lower their premiums. They may actually decide to forego flood insurance or increase their deductibles real high.

Statistically, the frequency of hurricanes might not have changed at all; nevertheless, how many of you would actually create a mathematical model to figure all this out before you decide to adjust your insurance policy on your home? I can tell you one thing though: your insurance company certainly will.

Investing Too

Recency Bias crops in when investing as well. No surprise here right? Imagine you need to invest ten thousand dollars but the market has recently experienced some really bad days. Are you more likely to put your money to work, or try to “wait it out”? Long-term, you know that the markets can provide a good opportunity to generate favorable returns (or at least you should know this). But it’s quite possible you might decide to sit on the sidelines until the markets “calm down”. That is, unless you’ve read this post and others on this blog.