PSYCHOLOGY OF INVESTING

Michael Pokrovski
Admin
Iscritto: 2022-07-25 11:51:03
2024-03-08 09:37:17

Psychology can play a significant role in the investment journey. We provide guidance for investors to understand and navigate. While creating an optimal investment strategy and portfolio is a financial optimization issue, psychology can play a significant role in the success of the Investment Journey.

WHY IS PSYCHOLOGY SO IMPORTANT?

While finance is built on models of "rational agents" who seek to maximize utility, everyday decisions are influenced by emotions such as fear or greed. In fact, history is replete with episodes in which non-financial factors, or “animal spirits ,” have driven markets.

By taking psychology into account, we can better understand investor behavior to improve our own investing approach. As human beings, we are prone to behavioral biases—systematic deviations from rationality—that can influence decision making and potentially reduce profitability.

WHAT DOES THIS MEAN FOR AN INDIVIDUAL INVESTOR?

Any investment plan must be tailored to the investor. In practice, this means identifying investors' behavioral tendencies and taking steps to maximize the chances of sticking to the plan, especially during difficult times.

Below are three examples of behavioral trends and their investment implications. Through specific solutions, specific go-to-market strategies that provide comfort (such as staggered entry), or clearly defined triggers for action, a consultant can help find ways to mitigate the impact of these biases.

SHOULD I WAIT UNTIL THE UNCERTAINTY PASSES?

Investors like Investor B are often tempted to wait for clarity before investing. Unfortunately, there are always reasons to doubt. The availability heuristic, a rule of thumb for thinking that causes [some, especially potentially negative and dangerous] events and data to carry more weight and therefore be more accessible in the mind, is a key factor. As investors become overly focused on certain headlines, uncertainty and indecision grow, overshadowing the long-term data and trends that drive markets over the long term. [We will always find a reason for anxiety and fear]

This is why waiting for the "perfect timing" can often result in you sitting on the sidelines longer than expected, potentially missing out on a rally while inflation erodes wealth.

 

HOW TO PREPARE FOR RISKS?

Investors concerned about risk may consider hedging. A core-satellite approach, in which a satellite hedging portfolio complements the main portfolio, can make it easier to maintain an investment. This may be preferable to a binary situation where you are in the market if you are optimistic and get out of it if you are pessimistic.

However, the impact of risk events on the market can be unpredictable. There is also the possibility of risks that were not considered—unknown unknowns.

One proactive action an investor can take in this case is to have a well-diversified portfolio. Owning different asset classes, sectors and regions can provide one of the few ways to protect and benefit from unexpected events.
Finally, diversification can help dampen volatility and, as a result, protect the investor from the emotions it can cause. This provides the building blocks for clear and rational decision making.

 

WHY INVEST AGAINST A WORSE SITUATION?

As noted in the macroeconomic chapters, we are approaching the next economic downturn. But that shouldn't necessarily be a cause for concern for long-term investors. After all, slowing growth is not necessarily synonymous with the near-total collapse of advanced economies that we experienced in 2008. But why risk capital when so-called risk-free cash returns are so attractive?

Cash can certainly provide short-term comfort, but in the long term the costs associated with lost investment returns and inflation erosion must also be taken into account.
Barclays Equity-Gilt research, which examines the performance of UK asset classes from 1899 to 2022, shows that over 2 years the probability of equities outperforming cash was 70%, and over 10 years this figure rose to 91%. However, past performance is never a guarantee of future results.

The figure below shows a similar picture with the five-year rolling returns of a hypothetical 60/40 cash-inflation portfolio of US bonds from 1927 to the end of 2022.

The probability of the portfolio outperforming cash on a 1-year basis was 62.7%, while on a 10-year and 20-year basis it was 78.8% and 78.7%, respectively.

WHERE ARE THE INVESTMENT OPPORTUNITIES?

As investors, we strive to select a combination of assets that will provide the most appropriate risk-adjusted returns over the medium term. That's why , recession or not, what matters most is how stocks, bonds, commodities and other asset classes react to future macro and microeconomic events.

Investing is not just about “the market.” It's also about companies. Quality, well-run companies do not necessarily cease to be so because of a bleak macro environment.

Likewise, much market news can be just noise, and investors must think about market events in the context of their own portfolios and goals.

Investors should also be mindful of their time horizon, as this can both open up new opportunities and prevent irrational decisions. For example, those who invest with the intention of passing on wealth to the next generation can benefit from the illiquidity premium offered by some private assets.

WHAT TO DO IF INVESTING SEEMS UNCOMFORTABLE?

Investors earn a return on their invested capital for taking on risk, and higher risks typically bring higher expected returns (and potentially higher losses). Therefore, to earn a return above the risk-free rate, you need to accept the discomfort that comes with volatility and uncertainty.

Investors can:

  1. 1. Accept that price and get a long-term return that will generally be linked to the return profile of the assets they own.
  2. 2. Hold assets with lower volatility and accept lower expected returns. This may reduce discomfort, but it may also affect the investor's ability to achieve his long-term goals.
  3. 3. Try to make a profit while avoiding the market timing fee. However, it is a difficult sport that can be expensive. In investing, as in life, humility is necessary.

 

IS HISTORY RELEVANT IN THE NEW CONDITIONS?

While history doesn't repeat itself exactly, it can rhyme. Markets move in cycles, with periods of growth followed by periods of decline. Likewise, market sentiment often fluctuates between euphoria and panic.

The further into the past, the more general historical conclusions should be. The key lesson is that throughout history, despite disruptions, the long-term drivers of growth in markets—human ingenuity and technological progress—remain in the background. We do not believe there is any reason for this to change.

From an emotional perspective, investors often find it easier to buy and hold investments in good times and harder in bad times. But it's when the herd mentality becomes extreme that real opportunities usually arise.

HOW CAN I GET AN ADVANTAGE IN 2024?

In what looks to be a testing year for investors, timeless investing principles coupled with strong behavior can improve the odds of success.

A sound investment process that builds a well-diversified portfolio of quality companies should provide a solid foundation for adequate returns over the medium term. But to do this, the investor must be able to hold onto the portfolio during difficult times.

The key point in this case is awareness of your own behavioral tendencies. A solid foundation for making clear, rational decisions increases your chances of mitigating risks and seizing opportunities.

This should give investors an edge in 2024 and beyond.

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