The sharp sell-off we saw back in August serves as a reminder: even in the calculated world of investing, human psychology plays a pivotal role. Market fluctuations can influence decision-making, even for the most experienced investors.

This month, I'd like to explore a topic that's particularly relevant in times of market uncertainty: behavioural finance. Understanding the psychological factors that drive our investment decisions isn't just academic – it's a powerful tool for building wealth.

Fear and greed: The emotional pendulum 

In today's landscape, where information flows freely and markets can shift on a tweet, understanding our own psychological tendencies is more important than ever. It's not about eliminating these biases – they're part of human nature – but about recognising and managing them effectively. Ask yourself:

• During the recent volatility, did you feel an urge to make significant portfolio changes, despite your long-term strategy remaining sound?
• Have you ever hesitated on a promising investment opportunity, focusing more on potential losses than probability-weighted outcomes?
• After a series of successful investments, have you ever felt an increased certainty in your ability to time the market?

If any of these scenarios resonate, you're not alone. The August sell-off serves as an example of how these emotional forces can play out in the market. During sudden downturns, fear can take the driver's seat, potentially leading to hasty decisions.

A useful tool for gauging these market-wide mood swings is the Fear and Greed Index. "Fear" (0–45 on the scale) represents periods of market anxiety, while "greed" (55–100) indicates optimism, often leading to aggressive buying. During the August sell-off, the index dipped into "extreme fear”.

Two months later, the index is now at “extreme greed” – a demonstration of how quickly sentiment can change. Research has shown that emotional stability in the face of market fluctuations yields better results1. By being aware of these emotional swings – both in the broader market and in our own decision-making – we can better position ourselves to make more goal-oriented choices.

The first step is knowing 

Behavioural finance emerged in the 1970s as a challenge to the "efficient market hypothesis," which assumed investors always act rationally. Pioneering research from Daniel Kahneman2 (psychologist, economist, and renowned author), Amos Tversky3 (cognitive theorist and mathematical psychologist), and Richard Thaler4 (behavioural economist) demonstrated that human decision-making is often far from rational – especially when it comes to financial choices.

For their work, Kahneman won the Nobel Prize in Economic Sciences in 2002 on “prospect theory” in collaboration with Amos Tversky. Thaler was awarded the same Nobel Prize in 2017 for his contributions to behavioural economics.

Here are some cognitive biases, and how they might impact your investing decisions:

Anchoring: This is the tendency to rely too heavily on the first piece of information encountered – the "anchor"3. This can lead to missed opportunities or overvaluation as market conditions shift.

Example: You hear that a stock is worth $100, and start to use that value as a reference point, even if new information suggests a different valuation.

Herd behaviour: Investors tend to follow the crowd5, driven by the belief that others possess superior information or insights. This can amplify market trends, potentially leading to bubbles or crashes.

Example: During a market rally, you notice many investors piling into a particular sector or asset. Despite your initial reservations, you decide to follow suit, reasoning that so many people can't be wrong.

Loss aversion: According to the “prospect theory”, developed by Kahneman and Tversky, people feel losses more acutely than they do gains2. This asymmetry can lead to overly conservative decision-making, or holding onto underperforming assets too long.

Example: You've identified an investment opportunity in an emerging market. The potential returns are substantial, but you hesitate, focusing more on the loss potential than the probability-weighted outcomes.

Overconfidence bias: Investors often overestimate their knowledge and ability to predict market movements, often ignoring the role of chance in outcomes3. This can lead to excessive trading, risk-taking, and ultimately, poor returns.

Example: After predicting a few market movements, you start to believe you have a talent for timing the market, leading to more frequent trades and an excessive amount of risk.

The second step is doing 

Understanding these biases is crucial, but awareness alone isn't enough. Here are some practical strategies for incorporating these insights in a strategy that's both financially and psychologically robust:

Embrace systematic decision-making: Emotions can run high during market volatility – dollar-cost averaging is an effective strategy to counteract this. By investing a fixed amount at regular intervals, regardless of market conditions, you reduce the impact of short-term market fluctuations. This systematic approach also acts as a safeguard against impulsive decisions during turbulent times.

Reframe your time horizon: In an age of instant information, it's easy to get caught up in short-term market movements. Diversification plays a crucial role here – by spreading your investments, you're not only reducing risk, you’re also reinforcing a long-term perspective. A well-diversified portfolio is more resilient to volatility, and over the long term, markets usually rebound from declines:

Diversify your information sources: Echo chambers can reinforce our biases. Actively seek out diverse perspectives on market conditions and investment opportunities. This might include contrarian viewpoints, emerging market insights, or analyses that challenge your current positioning. By broadening your information landscape, you're less likely to fall prey to overconfidence or anchoring.

A psychologically robust strategy

Whether you're reassessing your portfolio or considering new opportunities, take a moment to reflect on the psychological factors at play. Are your decisions driven by reasoned analysis or influenced by biases?

Remember, the goal isn't to eliminate emotions entirely – we’re still human, after all. Instead, it's about harnessing our understanding of behavioural finance to create a more resilient investing strategy. That’s something that can help you stay true to your financial goals.

If you'd like a different perspective to help ensure your portfolio remains aligned with your long-term objectives, feel free to reach out to your Wealth Advisor