Normalcy Bias: How It Could Affect Your Investing

What Is Normalcy Bias?

Normalcy bias describes the tendency to miscalculate the potential negative impact of a crisis or an adverse event. People often have a hard time coming to terms with the urgency of a disaster or an emergency, sticking to the belief that nothing serious will happen and that the situation will go back to normal, even if there are warnings indicating otherwise. It’s commonly referred to as denial.

This bias hinders them from taking actions that might negate or limit the impact of a crisis or catastrophe, including one threatening someone’s investments.

The early stages of the COVID-19 pandemic provided a clear example of normalcy bias. Although public health officials urged people to take steps such as social distancing, many people continued their normal lives, with social media feeds and news broadcasts showing images of beaches and bars at full capacity.

Despite all the warnings about the seriousness of the situation, the normalcy bias underpinned people’s inclination to continue with their pre-pandemic routines, potentially exacerbating the spread of the virus.

Understanding Normalcy Bias in Investing

It is easy to see how the tendency to believe that everything will be fine—even when signs indicate otherwise—could be dangerous when it comes to investing. Normalcy bias could lull investors into a sense of complacency about the markets. The assumption that markets always trend higher over time and recover quickly from any downturns may contribute to poor investment decisions.

For example, let’s say you own stock in a company that has been struggling, and its value begins to plummet. Normalcy bias might make you more likely to hold onto the investment as your losses mount, trusting that the company will eventually turn things around and that the stock is bound to recover. If the price continues to plunge and your shares become worthless, your failure to react to the initial red flags has suddenly cost you in the form of steep investment losses.

Examples of Normalcy Bias in Finance and Investing

The tendency to remain optimistic despite signs of a brewing financial storm can lead investors to strategies that disregard or underestimate the downside risks that they face. Here are a few specific ways that normalcy bias could interfere with your financial and investment decisions:

• Holding onto losing investments: Normalcy bias could make you less likely to recognize when it’s time to sell an investment that is heading downward. In addition to magnifying your losses, this costs you the opportunity to reinvest in another asset with a higher likelihood of success.
• Taking on too much risk: If you invest under the assumption that nothing can go wrong, you have a good chance of becoming overexposed to risky investments. This could set you up for a big loss if there is a drop in the markets or an economic crisis.
• Failing to diversify your portfolio: Investing in a diverse variety of assets is a time-tested way to manage risk. However, normalcy bias could make you overconfident about a certain area of the market, causing you to overinvest in that sector.
• Becoming complacent about market performance: Normalcy bias may affect investors more intensely during lengthy bull markets. Years of consistent growth could make you adopt a complacent and uncritical approach to investing, leaving you unprepared for the ensuing stages of the economic cycle.
• Following the crowd: Normalcy bias may reinforce your tendency to fall in line with major market trends, making you more susceptible to herd instinct. This could lead to buying investments based on media buzz, rather than conducting your own detailed analysis.

Tips to Avoid Normalcy Bias

When we think of the different ways that people are reluctant to react to a developing crisis, it may seem that normalcy bias is an inescapable part of human behavior. Luckily, when it comes to investing, there are a few things you can do to avoid letting denial or a false sense of security overshadow your decision making:

• Not confusing past results with future performance: Just because the markets or a specific stock have a proven history of stable growth, there is no guarantee that the uptrend will continue.
• Keeping a critical eye on market risks: It can be tempting to view things through rose-tinted glasses, especially if you are seeing gains in your portfolio, but you should try to remain realistic about the possibility of a slump or a negative shock.
• Being honest about your risk tolerance: Knowing how much risk you are willing to take on with your investments—and making sure your portfolio reflects that balance—can help you set realistic expectations and avoid falling into the trap of excessive optimism.
• Knowing when to cut your losses: If you are watching an investment plummet in value, you should aim to avoid letting inertia and inaction take over. You could consider using stop-loss orders to exit losing trades automatically before the normalcy bias nudges you toward holding onto the losing asset.
• Having a plan in place for emergencies: It’s difficult to prepare for an economic crisis, but if you have some strategies in mind, you’ll be more likely to take actions that will help you weather a financial rough patch.

The Bottom Line

Normalcy bias refers to an inclination to believe that the status quo will remain intact, even when signs are pointing to an upcoming transformation. The bias often plays out when people fail to heed warnings about impending emergencies. This famously occurred at the onset of the pandemic, but normalcy bias also might influence people to ignore an evacuation order ahead of a natural disaster.

Normalcy bias can affect investors by making them reluctant to recognize and respond to changing market conditions.