As far as we can tell, ostriches aren’t smart. And as far as we can tell, the average self-directed investor is smarter than the average person. However, there is also evidence that various psychological biases disproportionally affect smart people enough that their intelligence advantage is completely eradicated. One of these biases is the “Ostrich Effect.” There is a myth, started by the Romans, that ostriches bury their heads in the sand to avoid dealing with threats (in reality, ostriches are not to be messed with, and a kick from an ostrich can kill a lion). When applied to humans, the ostrich effect refers to our tendency to avoid thinking about current situations that we know are bad.

We might tape over the engine warning light on our car dashboard. We might avoid going to the doctor when we have a weird pain. We might not open bills until we get the envelope where we see the pink paper inside. In all of these cases, we know something bad needs to be dealt with but we’d rather ignore the problem than confront it.

It is hard to think of a situation where ignoring information is a good idea, and it is very detrimental to an investor. Studies have shown that investors tend to check their accounts more frequently when the market is going up. And this leads to them holding on to losing positions and selling winning positions. Because equity markets tend to go up, it is this latter issue that is most damaging. Holding on during downturns has historically been the thing to do. Most investors would do better if they never looked at their portfolios at all.

The idea of letting profits run and cutting losses is a vast over-simplification. The best rebalancing strategy is dependent on many other factors, and we will explore this in a future post. But this isn’t the only sub-optimal behavior that is caused by the ostrich effect. The world is always changing, and new information is always arriving. So, it makes sense to update views based on this new information. If you only do this when the market is going your way, your forecasts will never be current.

Unlike a lot of behavioral biases, the ostrich effect is easy to avoid once you know about it.

An extreme solution would be to avoid investments that have frequently reported updates. This is probably one reason why many people make money on their house purchase and comparatively few match the broad stock market. House prices aren’t marked to market, and the value of your house isn’t reported regularly on the nightly news. Unfortunately, if you adopt this solution, you will have to avoid the stock market and the associated large equity risk premium.

A better idea would be to automate everything. Have a system process information and algorithmically adjust your portfolio. If you can’t do that, have someone who can automate everything manage your investments. A defined process can keep your head out of the sand.

If you are a strict buy-and-hold investor, burying your head in the sand for a few decades is probably a good idea. But if you even dabble with market timing, the ostrich effect can be very damaging.

Disclaimer

This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting, or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact HTAA or consult with the professional advisor of their choosing.

Except where otherwise indicated, the information contained in this article is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution of any future date. Recipients should not rely on this material in making any future investment decision.