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Behavioural finance

The importance of an optimistic outlook

09 May 2023

Alexander Joshi, London UK, Head of Behavioural Finance

Key points

  • Even when markets are falling, retaining a healthy dose of optimism over long-term prospects can help investors focus on their investment goals
  • And as shown in human history, our relentless progress – often in the face of obstacles – moves on at pace. For instance, it could be the growing use of artificial intelligence that represents the next big leap in technology – raising productivity and economic growth in the process
  • It’s the same for investing. While investing can take people on a rollercoaster ride of emotions, especially when valuations are plunging – being optimistic about long-term prospects for stock markets is backed by decades of economic history
  • By sticking to your plan and retaining a well-diversified, balanced investment portfolio is usually the best policy for long-term investing – however uncertain the future might seem

Due to the way our brains are wired, it is natural, particularly during period of volatility in financial markets, to focus on the downside when it comes to portfolio returns. However, to be a successful investor it is important to balance attitudes towards portfolio gains and losses, and the emotions that are associated with them. 

Being too pessimistic on the outlook for markets, or individual stocks, might be costly. Being prudent and considering risks need not mean being overly cautious and limiting the upside potential for long-term gains. 

For example, cash provides safety and comfort, and has performed well in the face of much market turbulence over the last year, compared to other asset classes. However, over many years, will it provide adequate returns to preserve and grow wealth versus risk assets? History shows this not to have been the case; inflation erodes the value of cash, which is a guaranteed capital loss (assuming insufficient savings rates, and/or strategies, are in place to counter it). 

Investing in human ingenuity 

While never a guarantee of future performance, history provides reason for investors to be optimistic because of the power of innovation, which is what drives economic growth and markets. 

Humans are ingenious creatures, and throughout the course of history people have had so-called eureka moments and pursued the continual improvement of every aspect of our lives. One such aspect relates to our mortality. The chart shows the dramatic improvement in life expectancy at birth, since 1960.

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Potential benefits of technological progress

Too much of a focus on the news headlines, can easily induce pessimism. Meanwhile, technology continues to improve. A good recent example is in generative artificial intelligence, such as the ability of ChatGPT to answer queries with human-like responses. Despite many unknowns and an element of fear, the technology promises many uses for businesses and people alike.

Whilst there has been much discussion about automation costing jobs, the counter argument is that these tools are likely to free up time for humans that can be put to better and higher-value uses. This reallocation of resources promises to raise productivity with positive implications for economic growth.

When you invest in markets, you are in essence investing in human ingenuity as much as anything else. It’s relentless progress, in the face of obstacles, should provide reasons for hope. Being optimistic about long-term prospects for stock markets, regardless of any short-term challenges, is backed by decades of economic history1. That said, doing so when market valuations are plunging can be difficult and requires investors to have composure. 

Sticking to the plan 

Having the right amount of optimism during challenging periods can help with making the right investment decisions and sticking to the plan. When shocks happen and hit portfolio returns, it can be challenging to keep looking on the bright side. 

However, extreme swings in volatility are part of the investment journey. The world, and investment markets, regularly face instability. But this need not prevent an investor from reaching their goals if they can see it through (and have the right strategies in place). At any point there are a host of risks, both in the present and on the horizon, that could suggest delaying making investments or even selling them.  

The reality is that falling markets eventually recover, due to the regular innovative developments already discussed. Bear markets, which are classified as falls of at least 20% from their peak, are typically much shorter than bull markets (those that are more than 20% above the prior bottom, and less frequent).

As a result, the long-term case for investing in risk-assets is strong, in particular when considering longer investment horizons. The Barclays Equity-Gilt study, which looks at the performance of UK equities against UK government bonds and cash from 1899-2022, finds that over any two-year period the probability of equities outperforming cash is 69%. Over a ten-year period, this rises to 91%. Nothing is guaranteed when investing but these numbers are certainly food-for-thought. 

You can have too much of a good thing

Whilst a healthy dose of optimism is valuable, it is also possible to go too far, especially during strong bull markets or a new investment craze, when sentiment is high (see chart). 

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Beware of optimism bias, where investors think that bad things can only happen to others and not themselves. This can increase portfolio risk as investors put in place less portfolio protection. In extreme cases, this can contribute to investment “bubbles” forming, and over-optimism can lead to overconfidence, which has been shown to lead to increased trading activity, and subsequent falls in performance. 

Striking a balance

Successful long-term investing usually involves striking the right balance between potential gains and losses when building a portfolio. It shouldn’t involve a binary situation of either being in the market when feeling optimistic, or being out of the market when feeling pessimistic. Instead, being invested while being aware of (and resilient to) the pessimistic scenarios, provides better potential for a rewarding experience.

A well-diversified, balanced investment portfolio is usually the best strategy for long-term investing. Such an approach can limit the impact of unexpected tail risks and reduce the volatility of portfolio returns. 

In the face of much uncertainty and heightened risk today, that also seem unlikely to reduce soon, the value and logic of being diversified across asset classes, sectors and regions, shines through. 

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Market Perspectives May 2023

Welcome to our May edition of “Market Perspectives”, the monthly investment strategy update from Barclays Private Bank.