When you think about investing, what do you use as a reference point?
Many investors use the Great Recession of 2008 as their reference point due to the financial turmoil it caused and they make future financial decisions based on this perspective.
Because of this crisis, millions of jobs were lost, the housing market collapsed and trillions in investable assets disappeared. Although the effects from this were felt for many years following, the U.S. economy has largely recovered. The stock market has been on a nine-year bull market run and housing is back (or mostly so) across the country.
But have you recovered psychologically?
The psychological effects of the Great Recession will likely last long after the actual economic impact is a distant memory. In fact, you could be impacted by the events of 2008 for the rest of your life—unless you actively work to fix your skewed perspective.
Why? Because of a little mental hiccup called “anchoring.”
Anchoring & Your Financial Behavior
Like all humans, you’re prone to thought processes that include some significant weaknesses. One of those weaknesses, which is particularly relevant to investing, is called anchoring. Humans are prone to put too much emphasis on an early piece of information, such as the 2008 financial crisis, and then make all future decisions from that point of reference.
The Great Depression is an extreme historic example of the lasting impact of anchoring. In many instances, the results of this economic destruction invaded the thoughts and habits of an entire generation—governing important aspects for their lives forever. Many of us can see the results in the lives of grandparents or great grandparents, who “pinched pennies” for a lifetime or never threw anything away because “you never know when you might need it.”
The Great Recession has a similar anchoring impact on many of today’s investors. During this crisis, some people couldn’t find work, some lost all the equity in their homes (or lost their homes), and others watched their retirement nest eggs wither. No wonder this crisis became the latest generation’s anchoring effect.
If you use the Great Recession as your anchor point, you may be excessively risk averse and prone to extreme worry about equity markets or other investments. Unfortunately, this anchor point could inadvertently be hindering your ability to adequately build your investment portfolio.
What Should You Do?
First, recognize anchoring for what it is—a psychological hiccup, not your current reality. Think about this: If you had missed the Great Recession, what point of reference would you use? The seemingly endless bull market? Housing bargains everywhere? With that perspective, you might become a highly aggressive investor willing to take a chance on just about anything—which could also become a problem.
The key is to remove any emotionally charged baggage, such as an early anchoring event, from your evaluation process. Instead of making investment decisions using a specific reference point—and building in an unwarranted bias—focus on your long-term goals. Then do all you can to improve your chances of investment success using the following criteria:
- Determine your optimal financial plan based on your objectives
- Develop an asset allocation guided by your risk tolerance
- Make regular contributions at the highest level you can afford
- Avoid chasing the next random payoff or running from perceived disasters
- Stick with your strategy
It may be so 2008 – but the Great Recession could still be influencing how you invest. It’s humbling to think that your thought processes might bias your ability to maximize your investment opportunities, but we all should acknowledge this blind spot to help overcome this bias.
Learn more about recency bias and how it fits into your overall financial strategy by reading our free Personal Capital Investor’s Guide to Volatile Markets.