A reminder of the lessons from behavioural finance

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History may not repeat itself, but it rhymes. This is a pattern evident in the history of financial markets as human behaviour comes to the fore at different stages of the market cycle.

Behavioural finance teaches us that investors go through a range of emotions when confronted with financial markets just as they do with life in general:

  • Optimism and irrational exuberance

We set off with optimism. There is a human bias to expect things to go our way, to believe that bad things don’t happen to us or that by taking big risks we will necessarily reap great rewards.

If expectations are met, we tend to get excited by the prospect of even greater returns. If things go particularly well we are exuberant about just how well we are going to do. We start selling bears’ hides before shooting any bears. At this point, we are at or near the top of the cycle. We are convinced everything we do will come off. We are getting carried away. We are riding for a fall as we think ourselves infallible.

We see excessive returns as normal and tend to underestimate the range of outcomes high levels of risk can produce.

These emotions coincide with the good times described by John Kenneth Galbraith in his book “The Great Crash of 1929”:

“In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly.”

  • Complacency, denial, hope

The second phase of the cycle occurs when the market stops going our way and begins to turn. At first, we anxiously seek confirmation things will sort themselves out in our favour.

When they do not, anxiety mutates to denial and then outright fear, as the value of investments fall. At this point, we typically act defensively and think about shifting from riskier assets to more defensive sectors.

  • Panic, capitulation, despondency

In this phase, the realities of a bear market can no longer be denied. Investors become desperate. Some panic and sell to avoid more losses.

Those who do hold on become despondent. They doubt markets will ever recover and vow to never again undertake such an investment. This phase is often when the best buying opportunities arise.

  • Scepticism, caution, worry

The fourth and final stage of the cycle sees investors sceptical about the rise in valuations. They are cautious and worried, wondering if this rally in the market can really last. They are generally reluctant to invest money in the market although valuations are still relatively low and opportunities are attractive.

John Kenneth Galbraith also wrote of the behaviour in the stage of the market (and business) cycle:

“In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”

A roller-coaster of emotions

This emotional roller-coaster quickly turns rational investors into irrational investors.

Diversified and coherent long-term financial planning is frequently jeopardised when investors are confronted by extraordinary events because our reactions are driven by emotions.

At times like this it is important to be aware of the emotions you as an investors are most likely to experience. Among the most common behavourial traps are:

  1. Irrational exuberance – when investors become over-confident in their ability to select winners
  2. Aversion to losses – research has shown that losses tend to cause about twice as much pain as the pleasure we derive from gains. When markets fall abruptly investors feel the sense of loss more acutely.
  3. Chasing past performance – our tendency to drop a well-diversified portfolio for some product or strategy whose past performance we extrapolate into the future. This is particularly true when there appears to be something for nothing in a transaction. If you cannot see why new wealth could be created by implementing an idea, you should be afraid and not rely on past performance to guide you.
  4. Timing the market – It is extremely difficult to correctly predict the market’s movements. It makes more sense to think about how long we plan to invest our money for and select an asset class that can deliver positive returns over that period with some margin for error.
  5. Failure to rebalance – the risk/return characteristics of an investor’s portfolio should be considered independently  of events in financial markets. That means selling high and buying low.*

*Kahneman, D. and Tversky, A. (1979) “Prospect Theory: An Analysis of Decision under Risk”

Diversification does not assure a profit and does not protect against loss in declining markets.

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

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