The past five years have been exceptionally volatile for global equity markets, with rationality and sensibility often tested. During times like these, behavioural finance, the intersection of psychology and finance, is crucial in offering a deeper understanding of the intricate relationship between human behaviour and financial markets. Fear and greed are two of the most powerful drivers of market performance in the investment world. Warren Buffett once said, “Be fearful when others are greedy and greedy when others are fearful”. While this makes perfect logical sense, it goes against the very essence of human behaviour, especially when faced with uncertainty and adversity, both of which can lead to volatile and often adverse market conditions. As investment professionals, understanding human behaviour in the context of stock markets is crucial to guiding our clients through their investment journey.
In early 2020, the world was rocked by a black swan event – a rare, extremely negative occurrence that is impossible to predict. At the time, humanity was facing an existential crisis due to the unknown impact of COVID-19 and its uncertain duration. Unsurprisingly, global equity markets plummeted. By 20 March 2020, the S&P 500 Index had declined 28.5% for the year and 46.7% since 14 February 2020. It may sound rudimentary, but market direction is a result of the interaction between buyers and sellers. To put it bluntly, in early 2020, there were many more sellers than buyers.
Herd mentality is when investors follow the crowd rather than make independent decisions. In times of adversity, moving with the herd is much easier psychologically. It is human to want to sell to curb further losses in your investment portfolios. This is because it is impossible to determine where the bottom of any market correction might be amid the noise and volatility. With the benefit of hindsight bias, this action would have had dire consequences because what followed was one of the sharpest market recoveries in history. By the end of 2020, the S&P 500 had gained 16.5%, primarily due to the significant quantitative easing (QE) that the US Fed, along with other central banks, had injected to stimulate the US economy.
Even though COVID-19 remained a constant factor over the next few years, consumer confidence and spending were high, and economic and corporate growth was robust, resulting in strong performances from US equity markets. Unfortunately, another result of the increased stimulus and spending was that inflation rose throughout 2021. Towards 2H21, global economists and commentators were at pains to convince themselves (and us) that inflation would prove transitory and interest rates would remain at their lowest levels since the aftermath of the 2008 global financial crisis. This highlights confirmation bias—the tendency to seek information that supports one’s beliefs while ignoring contradictory evidence.
In 2022, it became clear that inflation was not transitory and had reached persistently high levels, forcing central banks globally to raise interest rates at the fastest pace in history. For the second time in three years, market panic set in, but this time, it persisted for the rest of the year, and the contagion spread from equities to property, bonds, and even gold. By the end of 2022, history would show that it was the worst year on record for investors who followed a traditional balanced investment strategy (60% equities/40% bonds). After this, many investors would have avoided making any decisions that might have led to further losses, displaying what is known as regret aversion – where an individual decides to avoid the potential pain of regretting a choice, even if it means making a suboptimal decision.
Coming into 2023, investor sentiment was understandably very low, and consensus expectations amongst the biggest investment banks for equity market returns in the year ahead were equally bleak. As economies, corporates and individuals were forced to ingest the much higher interest rates, a global recession seemed like a fait accompli. Once again, the herd was positioned to reflect the very bearish outlook for the year ahead. Of course, and again with the benefit of hindsight, at the time of writing, the US economy has somewhat miraculously avoided a recession, thanks almost entirely to the average US consumers’ willingness to spend their way through any economic slowdown (consumer spending accounts for c. 70% of the US economy). Market participants warmed to the idea that inflation and interest rates had peaked and would start to come down rapidly, once again boosting economic and corporate earnings growth. This, combined with the excitement around artificial intelligence (AI), led to back-to-back years where US equity markets produced returns exceeding 20%. Animal spirits were high, and this time around, there were more buyers than sellers in the market. Once again, this is an example of confirmation bias.
Overconfidence bias was evident in 2024 despite persistent US economic uncertainties, including elevated interest rates, prolonged inflation, political tensions, and overvalued equity prices. By year-end, the US Consumer Confidence Index had peaked at a three-year high, reflecting investor overoptimism. As wealth managers, this reinforced the need for self-awareness and a disciplined approach to asset allocation, enabling our clients to maintain a long-term perspective and avoid irrational decision-making.
One of the most underestimated behavioural finance traits is loss aversion, which occurs when investors feel the pain of a loss more strongly than the pleasure of an equivalent gain. This has led many investors to conclude that the most effective way to avoid this feeling is by taking minimal risk when making investment decisions. The obvious pitfall of this strategy is that it will almost always lead to a suboptimal return outcome; taking an appropriate level of non-speculative risk will result in a higher return over the long term. Another aspect of loss aversion is our hesitance to sell an investment when it is in a loss position, even when the circumstances and fundamental reasons for holding the asset might have changed. Similarly, many investors suffer from anchoring bias, which fixates on past reference points rather than market fundamentals.
As investment professionals, we often face many of the same emotional biases discussed in this article when evaluating our investments. The benefit at Anchor is the collective calm of an investment team with a few hundred years of combined market experience. Nothing gives us greater joy than celebrating a strong year of market returns with our clients, but investment management and advice fees are earned in times of adversity. During these times, we draw even closer to our clients to guard against the potential emotional and psychological vagaries that take hold of us all and, if left unchecked, will lead to potentially detrimental investment decisions being made. It is of utmost importance for us to be reminded of the following:
- Investors will face several meaningful market corrections during their lifetimes. Since our investments are comprised of quality, non-speculative assets, a recovery will follow each correction. In other words, regardless of the direction the herd moves in the short or medium term, any correction will present a good buying opportunity over the long term.
- Harry Markowitz was quoted as saying, “Diversification is the only free lunch in investing” Constructing a well-balanced portfolio of investments across different asset classes will reduce the volatility of returns in the long run. We are responsible for strategically allocating investments across various asset classes—equities, fixed income, real estate, cash, and alternative investments—to optimise returns while managing risk.
- “The investor’s chief problem—even his worst enemy—is likely to be himself.” Benjamin Graham. Asset allocation remains one of the most critical factors in long-term investment success. Emotional and cognitive biases significantly impact asset allocation, often leading investors to make suboptimal decisions. By understanding these biases, we help investors navigate market complexities and remain focused on their long-term financial success.
By recognising the impact of cognitive and emotional biases, investors can make more rational decisions, avoid common pitfalls, and stay committed to their long-term financial goals. As investment professionals, our role extends beyond managing assets; we act as behavioural coaches, helping clients navigate uncertainty, resist emotional reactions, and maintain disciplined investment strategies. Integrating these insights into portfolio management can enhance decision-making, optimise asset allocation, and ultimately drive better investment outcomes.
At Anchor, our company slogan is ‘Navigating Change’. Change can be exhilarating and terrifying, but it is unavoidable. Being on the wrong side of change could be disastrous for anyone’s investment objectives. As the custodians of our clients’ financial futures, we endeavour to embrace change with you and all the behavioural finance impacts that this change may bring.
