MARKET INSIGHTS

Weekly market commentary

Aug 1, 2022
  • BlackRock

Beware behavioral bias in new regime

Market take
Weekly video_20220801
Emily Haisley
Opening frame: What’s driving markets? Market take

Camera frame 
Last week’s rate hike by the Fed is another sign that we have entered new regime and more market volatility may lay ahead. 

Title slide: Avoiding investor bias in an era of volatility 
We think that warrants careful thought about behavioral biases, as these subconscious influences on investment decisions are exacerbated by volatility. 
We look at three biases and what to do to avoid them.

1: Inertia bias 
First, inertia, an aversion to change, or only making small, insignificant ones – can be costly now if your portfolio is still positioned for the previous regime.

2: Disposition bias and the endowment effect 
A reluctance to rotate out of losing positions or mechanically adding to them, taking more risks to avoid the pain of a loss, is the disposition bias. 
 Another bias to be aware of is the endowment effect. It’s when investors keep assets they wouldn’t buy today.

3: Three methods to mitigate bias 
So how would we avoid bias?

First, imagine you have realized all your gains and losses. Then construct the ideal portfolio. Don’t abandon your investment process but move away from small changes anchored on status quo holdings. 
Second, think of future market events that signal when to take profit or cut losses. That’s why our midyear outlook shares the signposts we look at.

And lastly, openly discuss bias, acknowledging emotions regarding performance and risk-taking. 

Outro frame: Here’s our Market take 
We are following our own advice, overhauling portfolios to prevent biases and we stand ready to shift our market views.

Closing frame: Learn more:
www.blackrock.com/weekly-commentary

Investing biases

We highlight the top three behavioral biases to avoid in the new, volatile market regime – and give tips on how investors can try to overcome them.

Market backdrop

Stocks rallied and yields fell last week after markets concluded the Fed’s pace of rate hikes will slow. We are less sanguine and see a dovish pivot only later.

Week ahead

We are watching this week’s U.S. jobs report for any signs production capacity is on the mend. The labor shortage is a key production constraint.

Investors are strapped in for a market rollercoaster in a new regime of increased volatility. Views on central bank rates are shuffling fast, as last week’s market reaction to the Fed’s rate hike showed. We think this warrants careful thought about portfolio changes. But change is hard. Behavioral biases subconsciously influence investment decisions. We look at three biases likely to trouble investors, especially in this volatile market – and share tips on how to overcome these pitfalls.

Download full commentary (PDF)

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Investment themes

01

Bracing for volatility

Unprecedented leverage gives policymakers less maneuvring room, in our view. And the politicization of everything makes simple solutions elusive when they’re needed the most, we think. This leads to bad outcomes.

02

Living with inflation

We are in a new world shaped by supply. Major spending shifts and production constraints are driving inflation.

03

Positioning for net zero

Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story; it's a now story.

Pain vs. gain

Satisfaction with gains and losses in behavioral finance prospect theory

The chart shows satisfaction levels from gains and losses using an S curve. Highlighted in red, the bottom left part of the curve reflects a tendency to increase risk-taking to avoid more losses. Highlighted in green, the top left part of the curve reflects a tendency to lock in gains to avoid risk.

Sources: BlackRock Investment Institute, adapted from Daniel Kahneman and Amos Tversky, Econometrica 12 (1980). Notes: The chart shows satisfaction levels from gains and losses relative to a neutral reference point. Black boxes show satisfaction magnitude along the S curve of risk tolerance – from risk seeking (red line) to risk averse (green line).

The first bias is the disposition effect, or the tendency to hold losing positions too long and sell winning ones too soon. We expect the disposition bias to be most prevalent when investors are feeling stinging losses – like so far this year. Both stocks and bonds have racked up declines not seen since the 1970s this year. Behavioral finance finds that people feel the pain of loss twice as strongly as they experience an equivalent gain as pleasurable (the red versus green arrow in the chart). As a result, people may hold on to losing positions to avoid the pain of a loss (bottom left in chart). Meanwhile, it’s tempting to lock in gains too soon on winning positions because of a reluctance to take more risk for only marginal benefits (top right).

There’s a second bias that should really be public enemy No. 1 today for professional investors: inertia. This is a reluctance to make changes or making ones too small to affect performance. Why is this especially a problem now? The era of steady growth and inflation known as the Great Moderation is over, we believe. A new regime of increased macro volatility is in its place. Yet central banks appear to believe they can magically curb inflation and cause only a mild economic slowdown, as we wrote last week. We see more volatility ahead as markets have rallied on hopes the Fed is about to change course and relax policy. That optimism is misplaced, in our view. All of this calls for professional investors to change their portfolios more quickly. It will be costly, in our view, to just follow playbooks such as “buying the dip“ or make slow and minimal changes.

Endowment is the third kind of bias to guard against in the current market backdrop. Think of it as excessively deliberating over whether you may one day need something that sat collecting dust for years – whereas you clearly should be decluttering. People with this bias overvalue their assets. The longer they own them, the higher the price they demand to give them up. The endowment effect can lead investors to hold on to positions even after an investment strategy has played out. This can hurt performance. Positions often produce more returns earlier in their life spans, we find.

Tips to mitigate these biases

First, do a blank-slate exercise – imagine you have realized all your gains and losses. Then construct the ideal portfolio for the most likely market and macro environment over your time horizon. That doesn’t mean abandoning long-standing investment processes. Instead, consider portfolio changes without basing it on your historical portfolio holdings and performance. Second, think of future market events or performance thresholds that would signal when to take profit or cut losses. Making a plan can help determine how to react amid volatile markets and high emotions. This is the reason we give signposts for changing our views in our 2022 midyear outlook. Third, encourage open conversations about biases and the changes required to overcome them. Discuss your emotions after losses, examine mistakes even when performance is good, and weigh input from colleagues with an alternative point of view.

Our bottom line 

Beware of behavioral biases in investing. We are guarding against their pitfalls because we believe the new regime requires an overhaul of portfolios. We’ve reduced portfolio risk throughout this year. Our latest tactical move: an up-in-quality portfolio shift by downgrading developed market stocks and upgrading investment grade credit. We underweight U.S. Treasuries and overweight inflation-linked bonds, believing markets underestimate the new regime’s inflationary nature

Market backdrop

The Federal Reserve increased the fed funds rate by another 0.75% last week. U.S. stocks rallied as markets concluded the Fed’s pace of rate hikes will slow, while yields fell on news of stalling growth. The Fed still thinks hiking rates will only cause a mild slowdown. It has yet to acknowledge the stark growth-inflation tradeoff: crush growth or live with some inflation. We don’t see a policy pivot until 2023, as data show persistent inflation. Expect more volatility until the Fed changes course.

This week’s U.S. jobs report is front and center. The report will be key as the Fed looks to the labor market for further signs of healing in production capacity. The Bank of England (BoE) is set to increase interest rates again. But we think it is nearing the point where it changes course. To us, the growth cost of further rises will lead the BoE to live with inflation above target.

Week ahead

The chart shows that Brent crude oil is the best performing asset this year to date among a selected group of assets, while EM equities are the worst.

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of July 28, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point this year-to-date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.

August 3

Caixin Services PMI

August 4

Bank of England policy meeting

August 5

U.S. jobs report

August 7

China trade data

Read our past weekly commentaries here.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, August 2022

Note: Views are from a U.S. dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, August 2022

Legend Granular

Note: Views are from a U.S. dollar perspective, August 2022. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Read our past weekly commentaries here.

Emily Haisley
Behavioral Finance – BlackRock Risk & Quantitative Analysis
Jean Boivin
Head – BlackRock Investment Institute
Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Beata Harasim
Senior Investment Strategist – BlackRock Investment Institute

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