The psychology of investing

Please note: All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• By taking into account psychology, we can better understand investor behaviour to improve one’s own investment approach
• As human beings, we are prone to behavioural biases – systematic deviations from rationality – which can impair decision-making and potentially drag on returns
• One pre-emptive action an investor can take in this case is to hold a well-diversified portfolio. Owning a mix of asset classes, sectors, and regions can provide one of the few ways to both protect and capitalise on unexpected events
• In what looks to be a year which will test the resolve of investors, timeless investing principles, combined with strong behavioural resolve, could improve the odds of success in 2024.

When Harry Markowitz, the pioneer of modern portfolio theory, was asked about his own investment allocation, he said, “My intention was to minimise my future regret, so I split my contributions 50/50 between bonds and equities.” Psychology drove his behaviour.

Despite creating an optimal investment strategy and portfolio being a financial optimisation problem, psychology can play a significant role in the success of an investment journey.

1. Why is psychology critical?

Whilst finance is built on models of ‘rational agents’ that seek to maximise utility, daily decisions are influenced by emotions like fear or greed. In fact, history is littered with episodes where non-financial factors, or ‘animal spirits’ drove markets. 

By taking into account psychology, we can better understand investor behaviour to improve one’s own investment approach. As human beings, we are prone to behavioural biases – systematic deviations from rationality – which can impair decision-making and potentially drag on returns. 

2. What does this mean for the individual investor?

Any investment plan should be tailored to the investor. In practice, this means identifying investors’ behavioural proclivities, and putting things in place to maximise the chance of sticking to the plan, particularly in challenging times.

Below are three examples of behavioural tendencies and their investment implications. Through specific solutions, ad hoc strategies to enter the market whilst providing comfort (e.g. phasing in), or clearly identified triggers for action, an adviser can help find ways to mitigate the impact of these biases.

Investor behaviour tendencies and their investment implications

3. Should I wait for the uncertainty to pass?

Investors such as ‘Investor B’ (see chart 1) are often tempted to wait for clarity before investing. Unfortunately, there are always reasons to hesitate. The availability heuristic, a mental rule of thumb which leads to placing greater weight on events and data that are more dramatic and thus more readily available in one’s mind, is a key influence here. As investors overly focus on certain headlines, uncertainty and hesitancy increase, overshadowing the longer-term data and trends which drive markets in the long run.

This is why waiting for the ‘perfect time’ can often lead to sitting on the sidelines for longer than anticipated, potentially missing rallies while inflation erodes wealth.

4. How do you prepare for the risks? 

Investors concerned about risks may consider putting hedges in place. A core-satellite approach, where a satellite portfolio of hedges complements a core portfolio, can make it easier to stay invested. This may be preferable to the binary situation of being in the market when optimistic, and out of it when pessimistic. 

However, the market impact of risk events can be unpredictable. There is also the potential for risks that have not been considered - unknown unknowns. 

One pre-emptive action an investor can take in this case is to hold a well-diversified portfolio. Owning a mix of asset classes, sectors, and regions can provide one of the few ways to both protect and capitalise on unexpected events. 

Finally, diversification can help dampen volatility and, as a result, protect the investor from the emotions that it can induce. This provides the building blocks for clear and rational decision-making. 

5. Why invest against a worsening backdrop?

As outlined in the macroeconomic chapters, we are getting closer to the next economic contraction. But this doesn’t necessarily have to be a cause for concern for long-term investors. After all, a slowdown isn’t necessarily synonymous with the near collapse of developed economies we experienced in 2008. But why risk capital when so-called risk-free returns from cash are so attractive? 

Cash can certainly provide short-term comfort, but in the long term, the costs of foregone investment returns and the erosion from inflation also need to be taken into consideration.

The Barclays Equity-Gilt study, which examines UK asset class returns from 1899-2022, shows that over two years the probability of equities outperforming cash was 70%, and over ten years, this rose to 91%. However, past performance is never a guarantee of future performance.  

The figure below shows a similar picture with five-year rolling returns for a hypothetical 60/40 US equity-bond portfolio against cash and inflation from 1927 to end 2022. The probability of the portfolio outperforming cash on a 1-year basis was 62.7%, and for 10 and 20-years was 78.8% and 78.7%, respectively. 

5-year rolling returns of a 60/40 US equity-bond portfolio vs. cash and inflation, 1927-2022

Cash index: 3-month T.Bill. 60/40 portfolio: 60% SPX Index and 40% US T.Bond. All data from 1927-2022

6. Where are the investment opportunities?

As investors, we aim to select the combination of assets that will deliver the most appropriate risk-adjusted returns over the medium term. This is why, recession or not, what matters most is how stocks, bonds, commodities, and other asset classes will react to future macro- and micro-economic developments. Indeed, investing isn’t just about ‘the market’; it’s also about companies. Quality, well-run companies do not necessarily stop being so because of a gloomy macro environment. 

In the same way, much market news may simply be noise and investors should think about market events within the context of their own portfolios and goals. 

Investors should also remember their time horizon as this can both open up new opportunities, and also prevent irrational decisions. For example, those investing with the intention to pass on wealth to the next generation may be able to capitalise on the illiquidity premium offered by some Private Assets.  

7. What to do when investing feels uncomfortable?

Investors earn returns on their invested capital for taking risk, and higher risks typically yield higher expected returns (and potentially higher losses). Therefore, to earn returns over and above the risk-free rate, it is necessary to accept the discomfort that comes with volatility and uncertainty.  

Investors can:

a) Accept this cost and earn the long-term returns that will typically be associated with the returns profile of the assets they are holding 

b) Hold assets with lower volatility and accept lower expected returns. This may reduce discomfort but can affect an investor’s ability to reach their long-term goals

c) Try to earn the return while avoiding paying the price, by attempting to time the market. However, this is a difficult sport, which can prove costly. In investing, just like in life, humility is essential

8. Is history relevant in this new environment?

Whilst history does not repeat itself exactly, it can rhyme. Markets move in cycles, with periods of expansion followed by periods of contraction. Similarly, market sentiment often swings between euphoria and panic. 

The further back one looks, the more general historical takeaways should be. A key lesson is that throughout history, in spite of disruptions, the long-term drivers of the growth of markets – human ingenuity and technological advancement – continue in the background. We do not believe there is reason for this to change.

From an emotional standpoint, investors will often find it easier to get and stay invested in the good times, and find it more challenging in the bad times. But it’s when the herd’s thinking is extreme that real opportunities generally arise.

9. How can I gain an edge in 2024?

In what looks to be a year which will test the resolve of investors, timeless investing principles, combined with strong behavioural resolve, could improve the odds of success.  

A robust investment process, leading to a well-diversified portfolio of quality companies, should provide solid foundations on which to generate appropriate returns over the medium term. But, for this to happen, an investor must be able to hold that portfolio during challenging times. 

The key to doing so is to have an awareness of one’s own behavioural proclivities. Putting a plan in place to limit their impact can make it easier to stay the course. 

Strong foundations for clear and rational decision-making improve the chances of being able to mitigate risks and capitalise on opportunities. This should give investors an edge in 2024 and beyond.