The Personal Cost of Bad Behavior

Bob Sullivan
By Bob Sullivan
Writer

September 13, 2018

Editor's Note: We don’t often do breaking news here at PeopleScience. We prefer the slow drip of business trends and academic studies. And yet … This is the 10-year anniversary of the great crashes of the Great Recession, and the stock market is a great petri dish of not-so-great behavioral biases, so … Let’s consider a just-released survey and what it reveals.

Once bitten, twice shy. It's more than a clever phrase; it's an axiom with origins all the way back to Aesop's fables. And it might at least partially explain why Americans have some pretty wrong-headed, costly ideas about the stock market, the Great Recession and its aftermath.

How wrong-headed? Nearly half of Americans think the stock market (specifically, the S&P 500 index) is flat or down since the recession, when in fact, it's up more than 200% since 2008, according to a new online survey released Thursday by financial firm Betterment.

Why? That's a question worth exploring on the 10th anniversary of the collapse of Lehman Brothers, an event often recognized as the last straw that, when broke, triggered the recession.

These were dark times. At its lowest point, by March 2009, the S&P 500 fell 56%. Once bitten.

Things remained bleak for a while. It took a full 1,011 days to recover what had been lost during the recession. But by March of 2013, the S&P 500 reached its pre-recession highs, and kept on going. The market has continued its relatively steady climb through today. Since 2008, the S&P 500 index, the standard measure of the broad stock market, is up 200%. In fact, even if you were the unluckiest investor in the world, and put all your money in the market on the worst possible day since the Depression — the day before Lehman's collapse — you'd still be up 130% since then.

Forty-eight percent said they believed the market “had not gone up at all” since the Great Recession.

Plenty of Americans don't seem to believe it. When asked by Betterment in its survey, fully 48 percent said they believed the market “had not gone up at all” since the recession. Only 8 percent of those surveyed knew the S&P was up 200% in the past decade.

Twice shy.

This misperception has probably cost those Americans a lot of money. Those who kept their retirement funds in an ultra-conservative cash or cash-like account — or worse, just stopped participating in the market at all — have missed out on all those gains.

Why would people hold on to such a wrong-headed perception, even when contradictory evidence is so readily available? That's what we want to explore here at PeopleScience.com. We think cognitive biases can explain a good portion of this expensive mistake.

We'll start with once bitten twice shy, which some might call the snake-bite effect. That’s exactly what it sounds like: It's hard to love again when your heart is broken, and it's hard to invest again when you've been burned by the market.

Atlanta Fed President Raphael Bostic said as much on CNBC last week.

"There is a psychology going on here, where the Great Recession was so deep and it scarred people so significantly that they are reluctant to trust in long-term investments," Bostic said on CNBC's "Squawk Box."

To add a little more science to it, loss aversion is a very powerful, and very well-studied, cognitive bias. The urge to avoid losing money is stronger than the urge to make money, and that can have a dramatic effect on investment choices.

The classic loss aversion experiment, shaped by Amos Tversky and Daniel Kahneman, goes like this. Researchers asked people if they would make a bet based on a coin flip: Tails, they have to pay some amount — say $100 — heads, they'd win a little more than $100. Even though the bet is 50/50, subjects demand very high returns before they are willing to take the bet. Most won’t do it until they were $200 or $250. That 2:1 ratio has proven pretty consistent across experiments. In investing, this means people are irrationally driven to preserve their capital, and need an irrational return before taking risks. Told that a stock has a 60% chance of going up (and a 40% chance of dropping by the same amount), many investors won't buy it. That's a bet professional traders would make every time, because over the long haul, they'd win big.

The urge to avoid losing money is stronger than the urge to make money, and that can have a dramatic effect on investment choices.

(Qualifier: Of course, no one can predict the stock market's future with such specificity. These are just illustrative examples, and rough ones at that.)

A related principal is negativity bias. We tend to weight bad news more than good news. Dan Egan, Director of Behavioral Finance at Betterment, thinks this negativity bias extends to journalists, too.

The news reports about markets are biased towards fear and negativity: crashes are newsworthy, but steady growth isn’t, unless it’s to stoke fear of another crash,” said Egan, in a statement emailed to me. “It’s no wonder most consumers feel anxious and like they’re in the dark.”

Hindsight Bias, or look back tendency, might also be at play. This involves our human tendency tell ourselves, "I should have known" when something bad happens. As we beat ourselves up over our inability to predict the previous future, we become even more cautious about the next future, lest we make the same stupid mistake again. The simplest way to avoid that? Stay on the sidelines. ("I knew I should have sold all my stocks in 2007.”)

As we beat ourselves up over our inability to predict the previous future, we become even more cautious about the next future, lest we make the same stupid mistake again.

It's also possible that peak-end rule is at play in these misperceptions. People can't remember everything about events that occur, so they tend to remember the last thing that happened, and the most dramatic thing. Certainly, the market collapse, and loss of 50% of retirement savings, is seared in people's memories. It's predictable that they would overweight this information compared to the slow, steady rise of the market since then.

Then there's small sample size and confirmation bias. Many Americans' lives haven't returned to normal since the recession, or at least they think so: In the Betterment survey, 65% of those who said they were impacted by the crisis say they have “not fully recovered.” That makes sense. Millions lost their homes or their jobs, and many have been forced into jobs with lower salaries. So if your life is still a struggle, it's easy to see why you might have the impression that the stock market hasn't recovered either. If your family, or your community, is still struggling, that would only reinforce your point of view through confirmation bias. Each tale of woe reaffirms your world-view, while you discount each TV story about the stock market soaring or the economy recovering.

If your life is still a struggle, it's easy to see why you might have the impression that the stock market hasn't recovered either

Let’s be very clear: We're not saying you should invest in the market today, not at all. We don’t give investment advice. (Editor’s note: No, we do not.) In fact, history tells us bull markets don't last forever, and there will be a correction — perhaps several — eventually. We are simply noting how dramatically our experiences can bias our perceptions. A large number of Americans believe something that's demonstrably untrue about the stock market, and it has cost them a lot of money. Perhaps hundreds of thousands of dollars.

That’s how powerful cognitive biases can be.

Bob Sullivan
By Bob Sullivan
Writer

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