The Investment Scientist

Saliency Bias: The Veil That Hides the Danger

Posted on: March 27, 2020

crowdsource.jpgYesterday I wrote about this little mental quirk called the “availability bias” that could cost you a lot. I gave you an example, based on my conversations with clients and their propensities that I had to suppress. If an investor sold his portfolio four days ago at the bottom of the market based on his experience the prior week, and bought back yesterday because he was inspired by the 3-day 20% rally, he would have owned 20% less productive assets.  This is even though the total dollar amount is the same, since what he bought was 20% more expensive than when he sold it.

But most likely, this person won’t sense any loss, since after all, he owns the same dollar amount of stocks. How cool is that? He loses 20% of his wealth, his future income will be 20% less, and yet he barely notices it. It turns out there is another mental quirk that is playing games with him. It is called the “saliency bias.”

So what is the saliency bias? It basically says the more noticeable attribute gets more of our attention than the less noticeable one. Not only that, we assign more importance to the more noticeable attribute even though the reverse might be the truth. The dollar amount of your portfolio is highly noticeable, much more so than the number of shares in your portfolio. Therefore, your mind not only pays more attention to the dollar amount day to day, but also thinks the dollar amount at any given moment is more important than the number of shares in the portfolio. But wait a minute. In your retirement, it’s the total number of shares that will really count, not the value of your portfolio in some distant past. This is just common sense. But alas, unbeknownst to us, the saliency bias just perverts our common sense.

Another big danger the saliency bias hides is the risk of cash. 2% inflation year in and year out is barely noticeable. But over a 10-year period, it will erode 20% of your cash value, nearly 40% over twenty years. How does that compare to the danger of the market dropping 30% (or as I like to put it, the market giving us a 30% discount.) The market dropping 30% is highly salient, thus causing many investors to freak out. But the loss can be recovered if those investors just stay the course. But the 40% cash value that inflation will erode over the next 20 years can never be recovered. You tell me which is more dangerous!

A 20% loss here and a 40% loss there, pretty soon you will have little left. No wonder the typical person in America has abysmal savings for retirement. My biggest value as a financial advisor is not to beat the market by 0.1% for my clients, but to help them avoid these 20%, 40% losses they don’t even notice.

Schedule a 2nd opinion financial review, buy my wealth mgmt books on Amazon.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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