Lessons in behavioral finance: Herd mentality bias
Hi. My name is Omar Aguilar. I’m the CEO of Schwab Asset Management.
Market volatility rose significantly since the end of the first quarter as economic uncertainty continued to dominate the headlines. Economic growth has been surprisingly resilient, and inflation has finally showed signs of slowing down, even though the overall levels remain high and sticky.
Consumer spending and a tight labor market have provided enough support to the aggressive approach by the Federal Reserve in rising interest rates that have resulted in higher volatility and lower liquidity for overall markets. In addition, credit and lending standards have tightened recently after the collapse of Silicon Valley Bank and Signature Bank that have left investors with a lot of unanswered questions.
Well, we’re here to help. With behavioral finance concepts, we hope to provide you with some context and some answers on how to help your clients navigate these complex markets.
In periods of high stress, high volatility, high uncertainty, investors may have the tendency to make quick decisions and make changes to their portfolio that could prove detrimental to their long-term investment objectives. In fact, after the collapse of Silicon Valley Bank and reported by the Wall Street Journal, a study by Financial World showed that Google searches for “is my money safe” and “why banks fail” rose 43% and 90%, respectively.
Given the high levels of interest rates and ongoing concerns about the banking sector, your clients may be looking at overall their cash holdings and comparing those to other investment vehicles and to other investors. They may be asking questions to you, like, what should I do with my cash? Do I have enough liquidity in my portfolio? Is this a good time to evaluate the overall duration of my fixed-income strategy? Should I consider moving to a higher-yielding investment vehicle?
If you have had these types of conversations recently with your clients, especially after decisions by the Federal Reserve in raising rates or the collapse of a bank, your clients may be trying to imitate and emulate the behavior of other market participants, and that might be a sign of herd mentality bias.
Herd mentality bias is the tendency for investors to copy and follow other investors. Herd mentality bias is an emotional bias that is driven by the fear of being left behind that triggers a flight-to-safety reaction. Herd mentality bias will make investors follow the masses, follow the herd, even attempt to protect themselves and run away from a perceived threat.
So what can you do about it?
Number 1: stay calm, be objective, and avoid chasing yield. Sit down with your client, evaluate their cash strategy, and remind your client that time in the market is more important than timing the market. Evidence shows that making quick decisions in their portfolio does not necessarily help their long-term investment results.
Number 2: balance the long-term needs of your clients with their short-term wants. Emotional investors will come to you seeking to adjust their strategy in periods of high volatility. Evaluate potential adjustments to the strategy that are consistent with your client’s behavioral profile, that allow them to sleep better at night but without sacrificing the long-term investment objectives to their strategy or their risk profile.
Number 3: develop a systematic approach to adjust and rebalance the strategy of your clients. In periods of high volatility, remind your clients of that plan and try to follow those specific rules objectively and disciplined. During that period of time, evaluate opportunities to potentially reduce cost for the overall strategy and take advantage of potential tax-loss-harvesting opportunities.
Finally, in periods like this, with high levels of interest rates, higher levels of volatility, it is prudent to evaluate high-quality, short-term fixed income vehicles. And reconcile the potential opportunities for investment in that part of the curve, with your client’s investment profile, their long-term investment objectives, their client liquidity needs, and your client’s potential income needs.
For more information about behavioral finance concepts and to explore potential high-quality, short-term fixed-income solutions, visit us at schwabassetmanagement.com. Thanks for listening.
About the author
Omar Aguilar, Ph.D.
Chief Executive Officer and Chief Investment Officer