Normalcy bias is the tendency to assume that things will continue as they always have, leading individuals to ignore or underestimate potential risks, especially during crises.
This cognitive bias can significantly impact investment decisions, causing investors to ignore warning signs, become overconfident during bull markets, or freeze during downturns.
To overcome normalcy bias, investors should educate themselves on market cycles, diversify their portfolios, set and adhere to long-term plans, use stop-loss orders, regularly rebalance their portfolios, stay informed, seek professional advice, and practice mental flexibility to adapt to changing circumstances.
What is Normalcy Bias?
Normalcy bias, also known as status quo bias, is the human tendency to believe that things will continue to go as they always have. It’s the mental shortcut that tells us to stay put because change is unlikely.
This cognitive bias often surfaces during crises or situations where the status quo is threatened.
According to psychological research, normalcy bias can cause people to freeze or react inappropriately during disasters, believing that because something catastrophic hasn’t happened before, it won’t happen now. This can lead to delayed responses, which are particularly dangerous when swift action is needed.
In investing, normalcy bias might make you cling to a declining stock, assume that a booming market will continue indefinitely, or ignore signs of an impending recession.
But history tells us that markets are cyclical, and what goes up must come down—sometimes with a crash.
The Psychology Behind Normalcy Bias
Understanding the psychology behind normalcy bias can help you recognize its influence on your decision-making. At its core, this bias stems from our brain’s preference for cognitive ease. Change requires effort, both mentally and emotionally.
Acknowledging that something catastrophic could happen disrupts our sense of security, which is inherently uncomfortable.
Studies show that normalcy bias is also closely related to the concept of heuristics, mental shortcuts that help us make decisions quickly. While heuristics can be helpful in some situations, they often lead to errors in judgment, particularly in complex situations like investing.
Our brains are wired to favor the familiar. The status quo feels safe, even if it’s not. This is why, during a financial bubble, many investors will continue to pour money into overvalued assets, assuming the good times will never end.
Conversely, during a downturn, they might refuse to sell off depreciating assets, hoping that the market will rebound.
How Normalcy Bias Affects Investing
Normalcy bias can wreak havoc on your investment portfolio if left unchecked. Here are several ways it manifests in investing:
- Ignoring Warning Signs: During the 2008 financial crisis, many investors ignored the warning signs that were evident before the crash. Housing prices had been skyrocketing, mortgage lending standards had plummeted, and there were clear signs of an impending correction.
However, normalcy bias led many to believe that the housing market would continue to grow indefinitely. This resulted in catastrophic losses when the bubble finally burst. - Overconfidence During Bull Markets: When markets are on the rise, it’s easy to believe that the good times will last forever. Normalcy bias can lead to overconfidence, causing investors to take on more risk than they should.
They may ignore diversification principles, assume that the market will keep climbing, and make investment decisions based on the assumption that nothing bad will happen. This can result in significant losses when the market inevitably corrects. - Paralysis During Downturns: During market downturns, normalcy bias can lead to paralysis. Investors may hold onto losing positions, hoping for a rebound, rather than cutting their losses. They may also delay rebalancing their portfolios or fail to take advantage of opportunities in a bear market because they believe the situation will improve on its own.
- Failure to Prepare for Future Risks: Normalcy bias can also cause investors to underestimate future risks. For example, they may neglect to hedge their portfolios against potential downturns, fail to adjust their asset allocation as they approach retirement, or overlook the need for a diversified investment strategy. This can leave them vulnerable to market volatility and significant losses.
How To Overcome Normalcy Bias
Awareness is the first step in overcoming normalcy bias. Here are practical steps you can take to mitigate its impact on your investment decisions:
- Educate Yourself on Market Cycles: Understanding that markets are cyclical and that downturns are a natural part of investing can help you remain calm during periods of volatility. Study past market cycles, such as the dot-com bubble, the 2008 financial crisis, and the COVID-19 pandemic, to recognize the signs of overvaluation and potential corrections.
- Diversify Your Portfolio: Diversification is one of the most effective ways to protect your portfolio from the effects of normalcy bias. By spreading your investments across different asset classes, sectors, and geographical regions, you reduce the risk of significant losses in any one area. Diversification can also help you take advantage of opportunities in different markets.
- Set and Stick to a Long-Term Plan: Having a long-term investment plan can help you avoid making impulsive decisions based on short-term market fluctuations. Set clear financial goals, determine your risk tolerance, and create a diversified portfolio that aligns with your objectives. Stick to your plan, even during periods of market volatility.
- Use Stop-Loss Orders: A stop-loss order is an automatic sell order that triggers when the price of an asset drops to a predetermined level. Stop-loss orders can help you limit losses and prevent normalcy bias from causing you to hold onto losing investments for too long.
- Regularly Rebalance Your Portfolio: Regular portfolio rebalancing involves adjusting your asset allocation to maintain your desired level of risk. Rebalancing forces you to sell high-performing assets and buy underperforming ones, which can help you avoid the trap of normalcy bias during both bull and bear markets.
- Stay Informed and Seek Professional Advice: Keep yourself informed about market trends, economic indicators, and geopolitical events that could impact your investments. Don’t hesitate to seek professional advice from financial advisors or portfolio managers who can provide an objective perspective and help you make informed decisions.
- Practice Mental Flexibility: Mental flexibility is the ability to adapt your thinking and behavior in response to changing circumstances. Practice questioning your assumptions and consider alternative scenarios. Ask yourself, “What if I’m wrong?” and “What if the unexpected happens?” This mindset can help you avoid the pitfalls of normalcy bias and make more informed decisions.
Example: The COVID-19 Pandemic
When the COVID-19 pandemic hit in early 2020, markets experienced unprecedented volatility. Many investors were caught off guard and experienced significant losses as normalcy bias led them to believe that the market would recover quickly without significant intervention.
However, one investor, John, took a different approach. Recognizing the potential severity of the pandemic, he quickly rebalanced his portfolio, shifting assets from equities to safer investments like bonds and gold. He also increased his cash holdings to take advantage of potential buying opportunities.
John’s decision to act quickly and decisively, rather than succumbing to normalcy bias, allowed him to protect his portfolio from the worst of the downturn. When markets began to recover later in the year, he was well-positioned to take advantage of the rebound, ultimately outperforming many of his peers.
