As you’re investing your portfolio, do you find that you’re primarily focused on the possibility of another massive market decline like we saw in 2008-2009?
If so, you’re likely experiencing probability neglect, a powerful cognitive bias that causes us to concentrate on the worst possible outcome rather than the most likely outcome.
This can make us overly concerned about events that are rare, but dramatic and memorable, and it can lead us to act in ways that aren’t in our best interests.
Severe market declines of 50-60%, for example, are rare. Historically, the market has suffered 50-60% declines about every 50 years or twice a century. A twice-a-century event makes headlines—it even makes history—but it’s far more likely that markets will experience more modest pullbacks. Sell-offs of 5-10% are quite common. The S&P 500 has averaged three 5% pullbacks and one 10% decline about every twelve months.
Focusing on our biggest fears can warp our perspective
Probability neglect makes you feel like we are wisely preparing yourself for potential dangers, but focusing on your biggest fears can warp your perspective. It can make you see the stock market as a way to lose wealth rather than as one of the best ways to build wealth. Markets do experience declines, but most investors who have held stocks for 20 years or more have had gains.
Focusing on the worst-case scenario can also make you more risk-averse than necessary. We recently talked with an investor who has been out of the market since the 2008-2009 decline, for example, because he feared another massive drop. But he’s now missed out on many years of terrific gains during the market’s recovery (and if he was in cash, he’s effectively lost money to inflation).
How can you counter probability neglect? Here are a few ideas:
1. Try to keep your assumptions in check
Ask yourself if your fears are probable, not just if they are possible. It can help to put your assumptions in a larger context—perhaps by considering how often declines occur, or focusing on the long-term returns of stocks and bonds.
2. Rely on a disciplined strategy
While you may not be able to change your thoughts or feelings, there are ways to prevent those thoughts from dictating your behavior. A quantitative investment strategy like our Upgrading approach, can helps us make investment decisions based on numbers, not feelings or assumptions.
3. Talk with an advisor
Investment advisors can offer much-needed perspective. We’ve been helping investors take charge of their financial futures for 50 years, and we've been through a range of different market environments.