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Studies of investor behavior have found that we don’t always act rationally. We’re apt to make assumptions about the market – and often without even realizing it. And the trouble is, these biases can lead us to act in ways that aren’t in our best interest.
One powerful cognitive bias is called “probability neglect,” the tendency to focus on the worst possible outcome rather than the most likely outcome. This can lead investors to become too conservative.
You are experiencing probability neglect if, for example, you are primarily focused on the possibility of experiencing another terrible bear market. Devastating declines of 50-60% are usually rare. Historically, the market has suffered 50-60% declines about every 50 years or twice a century.
Probability neglect can make us overly concerned about events that are rare but dramatic and memorable. A twice-a-century event makes headlines—it even makes history. But it’s far more likely that we’ll experience a more modest pullback in the market. Sell-offs of 5-10% are quite common; the S&P 500 has averaged three 5% pullbacks and one 10% decline about once a year.
Probability neglect isn’t limited to investing. We see it in people who avoid swimming in the ocean because they’re afraid of sharks, even though far more people are killed each year by mosquitos than sharks. Mosquitos kill 750,000 people a year; sharks kill just 10. But as with bear markets, shark attacks make the news, while mosquito bites do not.
Focusing on Our Biggest Fears Can Warp Our Perspective
Probability neglect might make us feel like we are wisely preparing ourselves for potential dangers, but focusing on our biggest fears can warp our perspective. It can make us see the ocean as a death trap and the stock market as a way to lose wealth. But while oceans do have sharks and markets do experience declines, most people who swim in the ocean aren’t attacked by sharks and many investors who have held stocks over rolling 20-year periods have had gains. According to JP Morgan, stocks held 20 years had positive average annual returns from 1950-2013.
When investors are focused on the worst-case scenario, they can become more risk-averse than necessary. Some investors have been out of the market since the 2008-2009 declines, for example, and they have missed five years of terrific gains during the market’s recovery (and if these investors have been in cash, they’ve effectively lost money to inflation).
You may not be able to change your thoughts or feelings, but you can develop habits to prevent those thoughts from dictating your behavior.
The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. You cannot invest directly in an index.