Psychology and Investing: Perception, Meet Reality.
As human beings, we often hang on to certain beliefs even when the facts prove us wrong. When it looks to us like something is true, we may believe that it is, and seek out other opinions and news articles that affirm our beliefs. It hurts our egos to be proven wrong, so we gather up any confirming evidence of our ideas to avoid that pain.
When this happens with investors, behavioral finance specialists call it “confirmation bias”. That means that investors seek out opinions that confirm what they already believe on markets, and ignore or not seek out data that refute their opinions.
2018 produced a couple of perceptions about market performance that some investors are still hanging on to, even though the data seems to prove them wrong.
The first is the perception surrounding the Federal Reserve’s balance sheet reduction, also known as quantitative tightening (QT). The Fed began QT in 2014 after years of the opposite process, quantitative easing, (QE began after the global financial crisis, in 2009). With QE, the Fed sought to stimulate economic growth in the U.S. by lowering interest rates and buying up Treasuries and mortgages. And with QT, the Fed is reversing that process, raising rates and reducing its balance sheet.
The fact that QT is even happening means that the Fed feels that the U.S. economy is now on relatively solid ground compared to the years after the GFC. However, some investors fear that QT may cause another problem, which is removing liquidity from the market. Quite simply, when the Fed bought up $3.5 trillion in Treasuries and mortgage bonds, it put liquidity into the market. That infusion of liquidity meant higher prices for all types of assets, including stocks, bonds and real estate. QT reverses this process, and thus investors fear the Fed is “removing liquidity”. As the Fed begins to remove some of the trillions of dollars that have boosted the economy over the last few years, some investors fear that asset prices could fall and the cost of credit could rise.
So far, though, QT has not withdrawn liquidity from the markets. If the unwinding of Fed balance sheet assets was draining liquidity, the aggregate money supply (M2) and credit growth should contract. However, money supply and credit growth have both expanded since QT began, and the private sector is still supporting money and credit growth even though the Fed is not.
Further, even though the Fed’s bond buying program put liquidity into the system, quantitative tightening does not exactly work in the opposite way on this particular point. Central bank money, or deposits held by the Fed, is different from the money that people use on a daily basis. The Fed has not been printing more money in the time of QE, and this would be the way regular people can hold “Fed money”.
Another example of the disconnect between investor perception and market reality comes with last year’s level of market volatility. It seemed like 2018 brought a huge upswing in volatility, and it did, in comparison to 2017’s historically low level (as indicated by the VIX, the Chicago Board Options Exchange’s volatility measure). In reality, though, 2018 wasn’t that volatile a year. In fact, as seen in the chart below, volatility in 2018 was actually lower than the long term average. The chart shows the number of days in each year when the S&P 500 moved 1% or more up or down. In 2018, the S&P 500 moved 1% or more in a day 64 times, which was still below the VIX’s long-term average.
It is easy to understand the reasons for confirmation bias, but falling victim to it without even realizing it is also common. To overcome confirmation bias from an investment perspective, it is important to seek out contrary information by continually reading about and monitoring market data and news. It’s also helpful to talk to your consultant about market-related questions.
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