Much of this year has remained fraught with uncertainty and instability in the markets. This, of course, has caused many investors to become nervous and impulsive about their market decisions.
This article will help to ease some fears about market volatility and outline a behavioural approach to address emotional decision-making. Hopefully, this information will assuage fears that many investors have experienced over the past several months.
Definition of Behavioural Approach
Behavioural finance and guidance is the approach that closely analyses investor psychology. When dealing with money, particularly with high stakes and unstable markets, the brain becomes potentially vulnerable to fallacious reasoning and other faults within decision-making.
These sorts of faults inevitably produce more impulsive, emotion-driven investing decisions. Overall, this drops returns potentially lower than most other asset classes.
The behavioural approach goes beyond risk assessment and identifies fundamental behavioural triggers that lead to panicked or fear-driven decisions. Understanding how investors may react to volatility can help decrease emotion-driven decisions. In the long term, this likely yields better returns for investors.
Identifying Biased Thinking and Behaviour
Biases in an investor’s approach and understanding frequently lead to misinformed decisions. These come in the form of cognitive and emotional biases. Eventually, they yield to potentially poor investment behaviour.
Examples of Cognitive Biases
- Confirmation Bias: “Confirming” what is already suspected or considered. This leads to ‘cherry-picking’ of information which affirms ideas without fully considering all factors.
- Recency Bias: Short-term thinking, which adds undue weight to more recent experiences. This is a short-term perspective that fails to understand investments concerning the long-term. It can lead to a spiralling of investment choices that may not align with investor risk tolerance.
Examples of Emotion Biases
- Loss Aversion: Experiencing more pain of loss than the happiness of gains. Investors may overreact to even milder losses, which may cause the hasty selling of investments or holding of prior ‘winning’ investments.
- Familiarity Bias: Many investors keep their perspectives only on what they know or understand. This could cause blind spots in portfolio diversification and gaps in return potential.
Remembering the Past and Highs and Lows
As the cognitive bias of recency suggests, short-term thinking can induce panic in investment thought and action. This, of course, produces less-than-desirable outcomes — particularly long-term.
Another method of addressing this issue is to consider short-term experiences within the context of past market performance. The market always ebbs and flows. Political and economic circumstances have always impacted it.
None of these is a new phenomenon within the market. Accordingly, demonstrating this truth of the market could help curb panic and anxiety-driven decisions.
Managing Behaviour May Lead to Better Outcomes
According to researcher Stephen Wendel, behavioural management starts with properly understanding and assessing what leads to panicked decision-making. Typically, it follows a 5-stage process:
- Investment volatility: specific investments could face volatility
- Information discovery: investor learns of the volatility
- Emotion: emotional responses are triggered by this information — usually fear or anxiety
- Decision: a decision is made, fuelled by the negative emotional response
- Action: investors act on the decision with negative consequences
Financial planners can help mitigate the adverse effects of this process by understanding how it progresses and identifying key methods to stopping it. Utilising behavioural techniques can prevent impulsive decision-making and yield better returns for investors.
Key Points to Consider
Finally, a few additional points to consider can improve outcomes even more.
Understand Risk Profile
Clearly defining a risk profile within an investment portfolio helps to weather the storm of market volatility. In addition, recognising the reality of risk and responding based on predefined tolerance helps to address emotion-driven decisions.
Asset Allocation in Light of Behavioural Approach
Asset allocation connects to an improved understanding of risk profile both for investors and financial planners. Behavioural tools combined with asset allocation can better highlight risk and prevent impulsive reactions to sudden spikes in market volatility.
Remember Goals, Objectives, and Duration
Similarly, reiterating long-term goals and duration over time can amplify a behavioural approach in preventing emotion-driven decisions.
The entire investment portfolio represents a plan with a certain degree of risk, all laid out over a duration. Despite short-term disruptions, remembering goals and duration can ground emotional responses.
Combining traditional strategies with the behavioural approach represents a significant step in financial planning and management. This can help investors understand their own wealth management more directly — and prevent potentially costly changes made from a state of panic or anxiety.
James F. Chapman, “Beware of Behavioral Biases during Market Volatility,” The Driven Fiduciary, May 4, 2022.
Michelle Fox, “Here’s how to keep emotion out of your investment decisions amid a volatile market,” CNBC, Feb. 22, 2022.
PIMCO, “The Importance of Behavioral Guidance,” 2022
Wells Fargo Investment Institute, “The perils of trying to time volatile markets,” Sept. 28, 2021.
Stephen Wendel, “Using a Behavioral Approach to Mitigate Panic and Improve Investor Outcomes,” Journal of Financial Planning, Feb. 2008.
If this article has inspired you to think about your own unique situation and, more importantly, what you and your family are going through right now, please contact your advice professional.