Dow 20,000 – What Do I Do Now?
By Jon M. Duncan, CFP®
Lessons from Behavioral Economics¹
With the Dow Jones Industrial Average topping 20,000 and other major stock market indices hitting record highs, it is only to be expected that some investors might be getting nervous. It is human nature.
Unfortunately, relying on our natural decision-making instincts is not always a good idea when it comes to investing. In fact, behavioral economists generally agree: Making decisions under conditions of uncertainty – like deciding when to enter or exit the stock market – is not something we are inherently equipped to do. Said differently, our brains don’t always do a good job of evaluating probabilities.
Behavioral economics research suggests that when making decisions under conditions of uncertainty, we tend to rely on cognitive shortcuts or, in the parlance of psychology, heuristics. Instead of objectively analyzing the probability of an event or outcome we use these cognitive shortcuts to draw quick conclusions that tend to conform to our individual biases. Sometimes the conclusions we draw are at odds with the underlying, observed probability of the event or outcome happening.
Take, for example, our built-in bias to misconceive chance and predictability. Most people think that a sequence of events generated by a random process – like flipping a coin or daily closing prices in the stock market – will represent the underlying characteristics of that process even in the short run. In fact, the outcome of a coin flip and the closing value of a stock index – heads or tails, high or low – has no predictive value; it is simply the outcome of a random process. Yet, after flipping seven “tails” in a row we conclude that the next flip “must” be a “heads” and after successive new highs the stock market “must” be headed down.
There are numerous other examples of how our cognitive biases influence our decision-making. (If you want to read more we heartily recommend Daniel Kahneman’s best-selling book, Thinking, Fast and Slow.) The fact of the matter, as borne-out by behavioral economics research, is that we are our own worst enemies when it comes to making decisions under conditions of uncertainty. While it might be tempting to try to time your entry into and exit from the stock market based on current index levels, the odds are that you are relying on cognitive short-cuts and not objective analysis.
¹Much of this blog is based on “Judgement Under Uncertainty: Heuristics and Biases,” by Amos Tversky and Daniel Kahneman.