Behavioral Finance Series

Behavioral finance incorporates elements of psychology to explain the actual behavior of investors and the subsequent effect on markets, in contrast to traditional finance which posits purely rational investors and efficient markets. In a series of posts, we will go over the most common behavioral biases investors fall prey to and put them in the context of history or current 

Over the last decade, there have been many trends in market leadership, such as large cap outperformance over small cap equities, growth over value equities, and U.S. over international equities. These dynamics, and the belief that they will persist in the future, have led to large structural overweight positions in portfolios. Often beliefs are rooted in market fundamentals, but sometimes they can be inadvertently reinforced by confirmation bias. 

Confirmation bias is the tendency to search for, overweight and favor information that confirms existing views and opinions. It’s mirrored by an inclination to then overlook, discount and ignore information that refutes previously held views. Investors who support or oppose a particular investment view will often interpret news, research and data in a way that upholds their existing view point. Confirmation bias can also be exacerbated by its behavioral pitfall partner, recency bias, in which views on what may outperform in the future are reinforced by recent market moves.

For instance, the outperformance of U.S. over international equities could continue in the next economic cycle, but for the investor who strongly holds this view, it is important to combat confirmation bias by reviewing analysis and opinions on the alternate view. Looking at the relative performance of U.S. and international equities in the chart below, we see how relative outperformance ebbs and flows – and always has. There have been times where the U.S. has outperformed for a sustained period, only for dynamics to shift and international equites to then outperform.

Whether you are of the view that current trends will continue or that a catalyst just has to come along to change things up, when building out a mosaic of ideas around a strongly held view it’s key to check the support for the counter-view. When selecting investments or forming market views, we can combat confirmation bias by going out of our way to find facts, analysis and data that don’t coincide with our previously held views.

Cycles of U.S. equity outperformance have ebbed and flowed

U.S. dollar, total return, cumulative outperformance 

Source: Factset, MSCI, JP Morgan Asset Management.

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