Normalcy Bias: a factor to consider in your investment choices

DN89...Jybs

15 Apr 2024

Normalcy Bias

Normalcy bias is a cognitive bias that causes people to underestimate the likelihood of a disaster or crisis occurring, and to overestimate their ability to handle it if it does occur. It is a tendency to believe that things will always continue as they have in the past, even in the face of evidence to the contrary. This bias can cause people to be unprepared for emergencies and to make poor decisions in crises, leading to harm or loss.

The normalcy bias is often seen in situations where people are facing natural disasters, such as hurricanes or earthquakes, as well as in situations of political upheaval or economic collapse. People may assume that everything will be fine, even when there are warning signs or evidence to suggest otherwise, and may fail to take necessary precautions or make necessary preparations.

Normalcy Bias In Investing

Normalcy bias can also play a role in investing, as people may assume that the market will always continue to perform well, even in the face of warning signs or evidence to the contrary. This can lead to a tendency to hold onto investments for too long or to make investment decisions based on past performance rather than current conditions.

For example, an investor may continue to hold onto a stock even as its value drops, assuming that it will eventually bounce back, rather than cutting their losses and moving on. This can be a mistake if the stock is unlikely to recover, and can lead to significant losses.

Similarly, investors may be overly optimistic about the potential returns of certain investments, and fail to adequately consider the risks involved. This can lead to overinvestment in a particular sector or asset class and a lack of diversification in their portfolio.

Impact of Normalcy Bias On Investing

The impact of normalcy bias in investing can be significant and can lead to poor investment decisions and financial losses.

The normalcy bias can lead to taking on more risk than is appropriate, which can result in significant losses in the event of a market downturn or economic crisis.
It can also lead to a lack of diversification in investment portfolios, as investors may overinvest in certain asset classes or sectors.
The impact of the normalcy bias can be especially pronounced during periods of extended market growth, as investors may become complacent and assume that the good times will continue indefinitely.
This can increase risk and leave investors vulnerable to market fluctuations.
The normalcy bias can also lead to a reluctance to sell underperforming investments, which can result in missed opportunities to cut losses and reinvest in more profitable areas.
It can also lead to a herd mentality among investors, as they may follow the crowd and invest in popular assets or sectors, rather than conducting independent research and making informed decisions.

How To Minimize The Influence Of Normalcy Bias While Making Investment Decisions?

Here are some strategies that can help minimize the influence of normalcy bias while making investment decisions:

1. Stay informed:

Keep up to date with market conditions and news that may impact your investments. Seek out multiple sources of information to avoid a biased or limited view of market conditions.

2. Consider alternative scenarios:

Don’t assume that the future will mirror the past. Consider a range of scenarios, including worst-case scenarios, to ensure that you are adequately prepared for any eventuality.

3. Conduct thorough research:

Before making investment decisions, conduct thorough research on the asset or sector in question. Look for both positive and negative factors that may impact the investment.

4. Maintain a diversified portfolio:

Diversification is key to reducing risk and avoiding overinvesting in any one asset or sector. Make sure that your portfolio is balanced and well-diversified.

5. Don’t follow the herd:

Avoid the temptation to follow the crowd and invest in popular assets or sectors. Conduct your research and make informed decisions based on your investment plan and risk tolerance.

6. Avoid overconfidence:

Overconfidence can lead to taking on too much risk, which can result in significant losses. Be realistic about your investment skills and limitations, and don’t assume that past success will continue indefinitely.

7. Avoid emotional decision-making:

Emotional decision-making can lead to poor investment decisions. Try to remain calm and rational when making investment decisions, and avoid being swayed by fear, greed, or other emotions.

8. Monitor and adjust your portfolio:

Regularly monitor your portfolio and make adjustments as needed. Don’t be afraid to sell underperforming investments or rebalance your portfolio to maintain diversification.