Managing emotions during decision-making is important, as risk aversion can cost investors.
By Sam Lamas
Barry Ritholtz, chairman and CIO of Ritholtz Wealth Management, wrapped up day two at the 2017 Morningstar ETF Conference with a lively presentation on the role that fear plays in investing.
Many people underestimate the power of fear in investing. Ritholtz pointed out how dangerous fear can be, especially because investors tend to fear the wrong things. This is evident in the public's fear of taking on risk. In investing, risk is sometimes seen only as downside, instead of as a necessary part of achieving higher long-term returns.
Throughout his presentation, Ritholtz gave multiple examples of humans being controlled by irrational fears. He mentioned the film "Jaws" that came out in 1975. Since its premiere, sharks have been seen as menacing, man-eating predators. Growing up in Rhode Island, Ritholtz even remembers people staying out of the water that summer, out of fear of a shark attack. Although sharks are great predators they are certainly not deserving of this stigma. In fact, more people are killed by trying to take selfies. In the U.S. deer and cows are much more dangerous than sharks.
Ritholtz discussed a similar irrational fear that developed after the 9/11 terrorist attack--people were afraid of flying. This fear didn't come from a well-reasoned look at data, instead it was born from an intense, emotional response to a national disaster. When something as catastrophic as this happens, our emotions can get the better of us and seep into our decision-making process.
Fear-based or emotional decision making can only lead to bad judgment and outcomes in capital markets according to Ritholtz. In this example, the fear of flying prompted people to take to the road instead, causing 1,500 more travel deaths due to car crashes.
Why does this happen?
According to Ritholtz, emotional decision-making came in handy for our ancestors who had to survive in the wild. But today, it can make us miss out on returns.
In capital markets, these survival instincts turn into behavioral biases, such as availability bias and loss aversion. Availability bias is our tendency to overreact to attention-grabbing events. Ritholtz gave multiple examples of investors and the media shouting doomsday at every bump in the road--such as after the 2003 Bush tax cuts or the swine flu wcare of 2009--only to see the markets soar months later.