Close Look: Clinging to cash - a behavioural bias?

Clinging to cash - a behavioural bias?

Over recent years investors have hoarded huge amounts of cash, either in savings accounts or in term products. In 2024, the sum of $925 billion poured into money market funds in the US, bringing their total money market assets to a record level of $6.9 trillion . And this in spite of declining rates of interest on these savings. Why would investors choose to limit the return on their investments, when higher returns are potentially available elsewhere? Behavioural biases could hold the clue. These are the default thought processes, built into human brains, which can lead us down well-trodden paths to irrational conclusions. We consider a sample set below.

Psychologists have identified over 150 behavioural biases which can affect decision making . These tendencies, part of what makes us human, are particularly pronounced in times of stress. And they can be a powerful force in the world of investment. As an example, during periods of market volatility, investors can take fright. They assume the worst and sell their holdings after the markets have taken a tumble. Or they fail to take advantage of market dips by buying before they recover. In the grip of irrational thoughts, long term investment goals are abandoned and poor decisions are made.

Perhaps the most powerful behavioural bias in these circumstances is loss aversion, which has even been called 'investment kryptonite'. Studies have shown that investors can feel the pain of a loss far more intensely than the pleasure of an equivalent gain. It might not be logical, but they will strive to avoid this pain by opting for rock solid cash. Even if this is to the detriment of their investment returns. The situation is perhaps not helped by the language of the investment industry, which flags up the need to take risk in order to reap investment returns.

There are other biases which go some way to explaining the vast sums of cash in money market funds. Confirmation bias involves seeking out information which confirms an original, and possibly irrational, view. Think of it as an investment echo chamber. Anchoring bias, whereby investors place too much weight on the first piece of information they receive, refusing to admit the logic of further evidence. And herding bias, which involves making decisions based on popular trends, in effect being pulled along by the momentum of the herd. 

Professional investors, such as fund managers, will aim to sidestep behavioural biases by using rational processes when analysing the prospects for their investments. In this way they would aim to avoid recency bias, among many others. This is a common bias in financial markets, which favours recent events over historic ones. It is recency bias which leads some investors to give more emphasis to short term over long term performance, when assessing how an asset might perform in the future. Not a particularly logical step, once you analyse it.

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Behavioural bias can lead us to make life choices, and also investment choices, that on closer examination are not strictly rational. A wide range of biases can confirm our investment decision, but often at the cost of higher investment returns over time, with loss aversion perhaps the worst culprit.