The Fading Affect Bias in Investing: A Cycle of Risk

The Psychological Impact of FAB on Investing

Investing isn't just about numbers and market trends; it's also heavily influenced by our own psychology. One fascinating psychological quirk that plays a big role in how we invest is the Fading Affect Bias (FAB). This bias means that the negative emotions from past events fade faster than the positive ones. This mechanism plays an important role in helping us move on from previous pain and can explain why we often look back on stressful periods of our life and recall the silver linings of such events rather than the painful experiences that defined them. When it comes to investing, this psychological bias can lead to an underappreciation of risk and dissatisfaction with more stable investments.

We've all been there—taking a hit from risky investments like stocks, cryptocurrencies, or speculative ventures. The initial pain from these losses is sharp, making us cautious and pushing us towards safer bets. But thanks to the Fading Affect Bias, the sting of those losses fades over time. We start to forget just how bad it was and get lured back by the promise of high returns from risky assets. This cycle can be dangerous. Each time we dive back into high-risk investments, we open ourselves up to potentially big losses. Even though history shows us the risks, the fading of those negative emotions makes the past seem less scary, encouraging us to take those risks again.

A Trip Down Memory Lane: Construction Finance and the GFC

As an asset class, construction finance is often where we see investors forget past pains. In our April 2024 article, 'The Risk Premium of Construction Finance,' we highlighted that following the GFC, an Australian ADI faced impairments in 53.9% of their $2bn+ Construction and Development Loan Advances book. When evaluating investments, it's crucial to remember that not all ~10% returns are created equal; we need to look beyond the headline return to truly understand the risk involved.

The Appeal of Stable Investments

On the flip side, stable investments like bonds, savings accounts, or funds that target capital stability, like the Manning Monthly Income Fund, offer attractive but steady returns without the excitement of higher risk options. These are designed to protect capital and provide consistent income over the long haul. But in a market where high returns from risky assets are often in the spotlight, these stable returns can seem a bit dull. Investors might grumble about the lower returns from these safer investments, forgetting that their main job is to preserve capital and provide a stable source of income. The Fading Affect Bias makes this dissatisfaction worse, as the emotional memory of past losses fades, making the modest returns of stable investments seem less attractive.

Given the psychological traps of the Fading Affect Bias, it's crucial to see the value in investments that target capital stability. These investments offer a balanced approach, mixing growth and defensive assets to provide stability and growth. They're especially good for investors with low to medium risk tolerance and a medium to long-term investment horizon. Capital stable investments can help smooth out the emotional ups and downs that come with high-risk assets. By providing consistent returns and protecting against big losses, they offer a solid foundation for a diversified investment portfolio. This stability is particularly important during market downturns, where preserving capital is key.

Understanding the Fading Affect Bias and its impact on our investment decisions is essential for long-term financial success. While the lure of high returns from risky assets can be tempting, it's important to remember the lessons from past losses and the value of stable investments. Capital stable investments, with their balanced approach, offer a smart path to achieving financial goals while minimising emotional and financial stress. By recognising and addressing the influence of psychological biases, we can make more informed and rational decisions, leading to a more secure financial future.