Why The Affect Heuristic Is Dangerous For Investors (and How to Avoid It)
“The most important quality for an investor is temperament, not intellect.” – Warren Buffett
Recent studies prove that if a person has positive feelings towards something, they’re more likely to perceive that its benefits are high, and the risks are low. On the contrary, if you have a negative state of mind towards something, you are more inclined to magnify its risks and downplay its benefits.
We see this constantly in advertising. You have likely noticed that plenty of ads are emotionally-charged, yet say very little to nothing about the product itself. That’s because these advertisements can make us feel subconsciously “good” about a brand, and alter our rational decision-making capabilities in the process.
This well-documented behavior is known as the affect heuristic, and it applies to investing as well. It can drive investors to quickly arrive at conclusions through subjective criteria (how they feel) rather than objective statistics and facts.
For instance, plenty of media outlets frequently feature shocking headlines about short-term stock market dips. Naturally, these headlines and articles can inject fearful emotions into investors. As a result, our minds can trick us into seeing the stock market as more dangerous and risky than it actually is.
Looking at the data, it’s clear that historically, the stock market is likely to recover from drops; and often quicker than one might think. Since 2009, there have been 9 stock market corrections (or stock market drops bigger than 10%), similar to the one we experienced last week. For each past one, the market correction proved to be short-lived, and the markets went on to recover and reach record highs. If you let negative emotions cloud your judgment and you sold during one of those dips, you’d be sorely disappointed to have lost profits and missed out on those new highs.
Prudent investors are able to tune out the noise and focus on the long-term facts and data. They know that when it comes to investing, making emotional decisions is more akin to gambling than it is smart investing.
At LexION Capital, we can remove emotions from the equation, and we carefully invest your wealth through a bespoke, goals-based investment plan. Want to learn more? Let’s have a conversation.