The 2020 market plunge brought to light many of the natural tendencies that can undercut sound decision making even in more normal times.
Jeff Kreisler, Head of Behavioral Science
Here’s a silver lining to the COVID-19 black cloud: The pandemic-induced recession that hit the U.S. markets one year ago this month was a stress test that shows us how our biases can distort investment decisions. Now that we have had time to reflect, one of the best lessons investors can take away is the importance of recognizing and counteracting those biases so that we can make sound decisions—even when conditions are not dire.
Recessions are a part of modern economic life and may be expected to recur fairly regularly. So it’s wise to have a strategy for how to deal with them effectively by adopting good decision-making habits that can benefit you long before the next recession hits.
For investors, the consequences of recessions can been significant, as all recent recessions have produced a bear market (i.e., equities declined more than 20% from peak-to-trough).1
While all investors seek to avoid the damage market drops can cause, experienced investors may ironically be at greatest risk. Market veterans who’ve been through previous recessions are more likely to rely on past experiences to decide present actions. As the saying goes: “Generals always fight the last war.”
From a behavioral science standpoint, the desire to rely upon a recent, seemingly comparable event such as the 2008 recession is predictable, understandable and normal. When present conditions are unsettling and the future is uncertain, our instinct is to seek calm and surety through familiar assumptions, feelings and biases as we assess, analyze, evaluate and choose.
Yet no two recessions, as no two wars, are identical. To navigate a new recession successfully—indeed to make sound investing decisions on an ongoing basis—demands that investors take a “be here now” approach: They should pay attention to what is actually happening in real time and recognize their psychological reactions to the market.
It helps to have a good advisor. Then, you have the benefit of current relevant data, systematic processes and a clear-eyed focus on your long-term goals—as well as a psychological buffer between you and a world gone volatile.
It also helps to learn how to identify, and attempt to overcome, the mental shortcuts (also known as cognitive heuristics or behavioral biases) that prey on our all-too-human craving for certainty—even when what we view as certain is wrong.
The COVID-19 recession and a rush to assumptions
Think the best and brightest can’t fall into the “been here, seen that” trap? Just look at 2020. The global financial crisis of 2008 was so fresh on many investors’ minds that they saw parallels in the market plunge of March 2020—and ended up paying a price for that assumption.
In 2020, the media and economic forecasting professionals helped reinforce that assumption—with articles warning a “financial crisis” was developing (just as in 2008), and the pros pointing to a material increase in the probability that the economy would slip into “deflation” (financial crises are deflationary).
Of course, hindsight is 2020 (all puns intended). These concerns did not materialize: The global financial system did not slip into crisis last year. Deflation did not take hold.
These days, the pundits’ anxiety has flipped: Now they are worrying about inflation—and we think they’re wrong again. Worried about inflation? We’re not.
Fueling anxieties and reinforcing assumptions
The initial stage of the COVID-19 economic crisis was similar to 2008: Stress emerged in short-term funding markets—the sign of a potential financial crisis on the horizon. In particular, high-quality commercial paper (CP) spreads (i.e., yields over Treasuries) spiked, as they did in the fall of 2008 after the investment bank Lehman Brothers declared bankruptcy.
Yet 2020 was ultimately dramatically different from 2008. Just look at subsequent market returns. In 2008, a 28% three-month decline in equities followed the spike in CP spreads. Not so in 2020. Then, the same spike (statistically speaking) was followed by a 47% three-month rise in equities.
Two recessions—two different paths
What accounts for such different outcomes? The short answer is that policymakers acted much more aggressively and quickly in 2020 with their stimulus measures than in 2008. End result: The recession induced by COVID-19 turned out to be far milder than many feared.
The challenges in 2020 extended far beyond CP spreads. Look, in particular, at “quantitative hedge funds” (funds that trade off computer algorithms that use historical data and patterns). Quant hedge funds are only as good as the information embedded in historical data, which up until 2020 did not include the impact of a global pandemic.2
Quant hedge funds in general fared especially poorly: A passive 60/40 balanced investment portfolio outperformed the quant hedge fund complex by nearly 10 percentage points in 2020.3 Even several highly esteemed quant hedge funds that had stellar track records underperformed in 2020.4
But quant hedge funds weren’t alone. According to a report by Goldman Sachs, all market factors (except for growth) had negative returns in 2020, a year when a passive S&P 500 ETF investment yielded an 18.5% return.5
How to improve our decision making?
To help ensure we’re making sound investment decisions, it may not be enough to simply know intellectually that the past doesn’t predict the future. It also helps to fully understand, and set ourselves up to manage, the human biases that can derail investors.
Recognizing our cognitive shortcuts is the first, giant step toward preventing them from clouding our judgment. So here’s our quick guide to some of principles at play. Here, we’re talking about them in order from most relevant to our recent market experience to the least, but it’s important to be aware of all these human tendencies:
- Availability bias—When estimating how likely it is that an event will happen, we overvalue the information that is most available to us (i.e., whatever comes to mind most easily about that event). For instance, if shark attacks are in the news, we’re likely to overweight the probability of meeting Jaws ourselves. And if we’re trying to determine what will happen in a recession, we’ll look to the most available information about “recessions”: 2008’s very memorable Great Recession.
- Recency bias—Often working in tandem with the availability bias, recency bias occurs when we rely upon those experiences that are freshest in our memory. When it comes to what will happen in a recession, the events of 2008–2009 are not only the most available, they are also the most recent examples.
- Regret aversion—Regret is such a powerful, uncomfortable feeling that we make decisions just to avoid feeling it. Regret aversion happens when we make a choice now driven by the desire to avoid regret in the future. In 2020, many of us knew that recessions could be great investment opportunities, and a fear of missing out might have nudged us to draw hurried, less rational conclusions (based on our other biases listed here).
- Anchoring—When we rely too much on one particular piece of information—usually the first, and often most irrelevant, piece—to make a decision, it’s known as anchoring. The quick insight about the 2020 recession that reminded us of 2008 (i.e., a spike in high-quality CP spreads) could have anchored us to the wrong analysis of the big picture.
- Hindsight bias—When we reinterpret the past as more predictable than it actually was at the time, we suffer from hindsight bias. This is sometimes known as the “I-knew-it-all-along” effect, and can lead to faulty expectations in the face of similar events because the outcome of the past feels like it was obvious and predictable. If we thus see the 2008 recession as having had obvious, predictable results, we’d be inclined to believe the 2020 recession would have the same obvious, predictable results.
You can do it, and we can help
What more can we do to stop ourselves from taking damaging shortcuts both in bad times and in our daily investing? The answer is to have systems in place so that our decisions are made deliberately, not impulsively. We need to articulate assumptions and check them against the facts. And it helps to gain perspective from professionals who’ve earned your trust.
For more insights, reach out to your team at J.P. Morgan, and see our latest market commentary: Investors have embraced the optimism.
1 Rarely does a bear market occur outside of a recession (those in 1987 and 2018 were exceptions).
2 The 1918 “Spanish Flu” pandemic predates the recording of economic and financial data in a systematized way.
3 According to data from Goldman Sachs’s Prime Brokerage desk.
5 Alex Meintel, Jessica Binder Graham and Akash Chandgothia, Quantamentals: 2020 Factor Review (January 4, 2021), https://publishing.gs.com/content/research/en/reports/2021/01/04/bb4b65b2-8416-4eb1-bd0c-5e3cb5f09ba4.html (subscriber only).