CPD: Understanding investor behaviour – the value of advice (part two)

Understanding the importance of investor behaviour and decision making can assist in translating behaviours into value-adding client management.

Investor behaviour, positive and negative, cannot always be anticipated and can have a marked impact on client outcomes. This article, proudly sponsored by Russell Investments, examines the value of advice and within that, the importance of understanding investor behaviour.

Advisers are much more than investment experts – they have an equal role to play in helping clients navigate the emotions that can cloud financial decision-making.

Today, these emotional challenges are the reverse of just a few years ago.

Early this decade, COVID-19, global conflict and surging interest rates all triggered bouts of volatility that tested peoples’ fortitude as markets fell temporarily lower. Advisers played a crucial role in ensuring clients understood that a properly constructed portfolio could weather such extreme swings in the value of investments.

The challenge in 2024 has been curbing investors’ enthusiasm as the AI boom and anticipated interest rate cuts pushed markets to record highs. There is always a risk of investors falling into the trap of buying while markets are bullish and selling when sentiment turns bearish, as history shows it does.

This is where the adviser’s expertise in reweighting portfolios at regular intervals to maintain long-term financial plans is vital. Investors are more likely to grasp the benefits of that process when presented with the historical advantages of maintaining a steady investment strategy instead of chasing quick wins, then bailing when markets turn sour.

Successful investors recognise that the risk of loss is highest when markets are driven by euphoria – and, conversely, that market capitulation may present an opportunity.

What is behavioural finance?

Behavioural finance is a field of study that combines psychology and economics to understand how individuals make financial decisions. It challenges the traditional assumption that people always act rationally and in their own best financial interests. Instead, behavioural finance focuses on how psychological biases, emotions and cognitive errors can influence financial behaviour.

Much of traditional finance theory is predicated on rational investor behaviour that advocate the notion that financial markets are efficient. The efficient market hypothesis argues that current stock prices reflect all existing available information, making them fairly valued. It also suggests that people are free from emotion and make rational decisions based on fact.

However, behavioural finance would suggest this is not the case; instead it asserts that financial decisions around investments, income, risk and debt are influenced by human emotions, biases and cognitive limitations of the mind in processing and responding to information.

Key concepts in behavioural finance

There are a number of key aspects of behavioural conditioning that advisers would benefit from understanding. Each of these, and how they relate to investment decision making, are described as follows:

Cognitive biases – systematic patterns of deviation from rationality in judgment, such as:

• Overconfidence – where investors overestimate their knowledge or ability, leading to risky decisions.
• Anchoring –  or relying too heavily on the first piece of information encountered when making decisions.
• Loss aversion – which describes why the pain of losing is psychologically twice as powerful as the pleasure of gaining. The loss felt from money, or any other valuable object, can feel worse than gaining that same thing^[1]. People are more likely to avoid risks when thinking about potential gains and take risks when thinking about potential losses; for a client experiencing loss aversion, it’s better not to lose $50 than it is to find $50.
• Herd mentality – the tendency to follow what others are doing in the market. Defined by the Oxford Dictionary as “the tendency for people’s behaviour or beliefs to conform to those of the group to which they belong”, herd mentality manifests in finance when investors follow the crowd instead of their own analysis. It has a history of starting large, unfounded market rallies and sell-offs that are often based on a lack of fundamental support to justify either^[2].
• Confirmation bias – describes the tendency for individuals to seek out and prefer information that supports their own pre-existing beliefs and ignore any information that contradicts those beliefs. Confirmation bias is often unintentional but can still lead to poor decision-making in real-life contexts^[3].
• Recency bias – is considered to be a cognitive error identified in behavioural economics whereby the individual incorrectly believes that recent events will recur in the near future. This tendency is irrational, as it obscures the true or objective probabilities of events occurring, leading the individual to make poor decisions.

Emotions – feelings such as fear, greed, and excitement often influence financial decisions, particularly during periods of market volatility. This is explored more in the following section.

Mental accounting – individuals can sometimes categorise money into different “buckets” – for example, treading a bonus differently from regular income. This can sometimes lead the individual to make irrational financial decisions.

Cycle of investor emotions

A discussion of behavioural finance provides a good opportunity to revisit the Cycle of Investor Emotions (figure one). The AI propelled market highs would have many investors in the blue zone, experiencing the thrill – and sometimes euphoria – of markets reaching new highs. Although rate cuts have yet to meet market expectations, the prospect them have buoyed bourses around the world.

While unadvised investors may make rash decisions in this environment, advisers can manage clients’ emotions by explaining market cycles and how they might feel and respond at different points of the cycle. By educating clients, advisers can provide this ‘behavioural coaching’ to best position clients to ride out the vagaries of financial markets^[4] and prevent them from ‘buying high, selling low’.

Investors typically start with optimism, which sits at the inflection point on the emotional upswing. At this point, investors expect things to go their way, or they expect to receive a return for the risk of investing. Investors enter markets because they believe they will be able to grow their wealth through their investment choices.

When markets move in the direction the investor had hoped to see, they start to get excited about the possibility of even greater gains. This is when investors start hearing positive news stories in the media, coupled with tips from friends, colleagues and even Uber drivers…stories about how well their investments have done can spur investors into further action. This can be an attractive comfort zone because in such a scenario, investors are running with the herd.

When the momentum continues, investors can find the experience thrilling and begin to anticipate even higher returns – and sometimes start sharing their own tips!

As markets reach the top of the cycle, investors may experience euphoria.

At this point, the uneducated investor starts to believe that they made a smart move to invest when they did and believe that the good times will continue unchecked. In some cases, investors fool themselves into believing they can tolerate higher levels of risk and may begin to trade more frequently or invest in riskier asset classes.

The second phase of the cycle occurs when the market starts to turn. At first, investors watch anxiously to see if the downturn is just a blip. They may believe that things will improve shortly and therefore hang on to their investments. They often try to shield themselves psychologically from the bad news and move into denial.

As the market continues to fall, denial gives way to fear. Investment values decline and perhaps investors begin to see losses. Bad news stories proliferate in the media and online. When market losses accelerate, real fear kicks in. Some investors may then turn defensive and switch out of riskier equities to more defensive equities or other asset classes, such as bonds or cash.

In the third phase of the cycle, the realities of a bear market come to the fore and an investor may become depressed and desperate. Those investors who missed their chance to take profits may try to get their portfolio back into the black by either selling their worst-performing investments or moving into securities that don’t fit their risk profile. When that doesn’t work, panic may set in.

At this point, some investors feel at the mercy of the market and capitulate, pulling out altogether, abandoning investments at precisely the wrong time.

Those who remain invested may become despondent and wonder whether they should ever have invested their hard-earned money in the markets…yet this is the part of the cycle identified as the point of maximum financial opportunity.

In the fourth phase of the cycle, investors may experience some scepticism when markets start to rise. They often have a sense of caution or worry, wondering if market growth will last.

Though investors are hopeful about continued market increases, they may be reluctant to invest money – even at a point when prices are still relatively low, and opportunities are attractive.

Eventually investors come to realise the market is recovering. For those investors who let their emotions rule their investment decisions, the market cycle can begin all over again – unless of course they have good financial advice and understand the cyclicality of the market and the importance of staying the course in the asset allocation recommended by their adviser.

Time in the market

The journey of four hypothetical investors who each invested $100 in January 2020 may help sway their behaviour^[5]. Each reacted differently to the market downturn in March that year, recording different outcomes as result.

With reference to figure two:

• Mandy remained in the market and witnessed her $100 investment rise to $140 by June 2024 (blue line)
• Naizar instead moved to cash in March 2020 after his $100 fell to $87, re-entering the market three months later. His ultimate investment was worth $125 in June 2024 (orange line).
• Bhupinder also moved to cash in March 2020 but waited until the following New Year to re-enter the market. Her investment was worth $113 in June 2024 (grey line).
• Finn was worse off still – he also bailed into cash in March 2020 and has never re-entered it. The $87 he initially moved to cash is now worth just $74 in real terms due to the impact of inflation (red line).

The experience of these hypothetical investors highlights the fact that those investors who jump in and out of markets can mistime their entry and exit points. As figure three illustrates, missing out on even a small number of the market’s best days can have a real impact on the amount of capital that someone can accumulate over time. This counterintuitive result occurs because markets, while unpredictable, have a history of rising over the long term^[6].

Those individuals who remained invested in the S&P/ASX300 Total Return Index throughout the past 10 years built significantly more capital than those who missed just the 10 best days’ performance of the index in that period. Those who missed the best 20 days wound up more than 50% worse off than if they had remained invested for the full decade.

Without the guidance of advisers, investors can fall into the trap of buying when markets are rising and selling when sentiment drives prices down. There is real value in the ability of advisers to help clients maintain their long-term strategies in the face of unnerving volatility across all asset classes.

In another example, calculations show that regularly increasing or decreasing exposure to the US S&P500 Index by trying to time the market may have cost investors as much as 3.28% per annum in returns in the 21 years to May 2024, as shown in figure four.

Advisers who forge solid relationships with clients are best placed to convince them of the merits of maintaining the positions that underpin the financial strategies they formulate on their behalf. These conversations can be more difficult to instigate in good years – but prepare investors for the inevitable cyclical nature of markets.

Why understanding investor behaviour is important

There are several reasons an adviser and their clients will benefit from a good understanding of investor behaviour. These include:

• Customised communications – understanding behavioural biases can help advisers communicate more effectively with clients by addressing emotional reactions to market movements. For example, during a market downturn, recognising loss aversion allows advisers to calm clients who might want to sell prematurely out of fear.
• Tailored recommendations – while we know all clients have different risk tolerances, financial goals and objectives and preferences, each client also has different biases and emotional tendencies. Understanding these helps advisers tailor strategies that fit their clients’ risk tolerance and decision-making styles. For example, a client prone to overconfidence might need more conservative investment advice to mitigate risky behaviour.
• Risk management – investor behaviour can be influenced by emotions such as fear, greed and overconfidence. By understanding these tendencies, advisers can help their clients to avoid impulsive or emotionally driven decisions that may lead to poor outcomes.
• Long-term success – an understanding of investor behaviour helps advisers to guide their clients towards strategies that are more likely to lead to long-term success; this includes remaining committed to their investment plan through periods of market volatility.
• Avoiding common pitfalls – being aware of common behavioural biases such as herd mentality, confirmation bias, loss aversion and recency bias allows an adviser to recognise when a client might be making decisions based on flawed thinking. They can then provide guidance to alleviate these biases.
• Communication and trust – understanding how clients perceive and react to financial information and market events is critical for effective communication. An adviser who truly understands investor behaviour and its drivers can explain complex concepts in a way that resonates with the client, building trust in the process.
• Managing expectations – investor behaviour often includes unrealistic expectations about returns or the ability to time the market; an adviser can help set realistic expectations and educate clients.
• Emotional support – investing can be an emotional journey, especially during times of market volatility. An adviser who understands investor behaviour and the cycle of investor emotions can provide emotional support and act as a steadying influence for the client. That way, rash decisions driven by exuberance, fear or panic can be avoided.
• Helping clients stick to long-term plans – behavioural finance equips advisers to guide their clients to stay with their long-term financial plans, even when emotions (like fear during a crash or greed during a rally) threaten to derail them. They can also educate clients on the potential pitfalls of biases like herding, preventing clients from following the crowd in a volatile market.
• Building trust and deeper relationships – clients appreciate advisers who understand and focus on more than simply the technical aspects of finance. They appreciate an understanding of the emotional and psychological dimensions of decision-making. By addressing biases and fears, advisers build a deeper trust, positioning themselves as partners who not only manage money but also help navigate complex emotions tied to wealth.

By integrating the principles of behavioural finance into their practices, financial advisers can help clients make more informed, balanced decisions, particularly during periods of market uncertainty. The adviser who understands investor behaviour is better equipped to provide holistic financial advice that considers not only the financial aspects of advice, but also the emotional and psychological dimensions of investing. This leads to better long-term financial outcomes and a successful and truly valuable client-adviser relationship.

Read: CPD: Asset allocation – the value of advice (part one)

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References:
[1] Kahneman, D., & Tversky, A. (1977). Prospect Theory. An Analysis of Decision Making Under Risk. doi:10.21236/ada045771
[2] Investopedia https://www.investopedia.com/terms/h/herdinstinct.asp
[3] Scribbr https://www.scribbr.com/research-bias/confirmation-bias/
[4] Investopedia https://www.investopedia.com/recency-availability-bias-5206686
[5] Examples shown for illustrative purposes only.
[6] Russell Investments https://russellinvestments.com/us/blog/bulls-vs-bears-2