Why psychology matters in investing

Financial models are based on ‘rational agents’ focused on optimising returns, yet investors’ actions are often shaped by irrational emotions, such as fear or greed. Humans are prone to behavioural biases, which can undermine investment decision-making as well as portfolio returns. Understanding these tendencies, and their potential investment implications, can help you improve your approach.

Here are three common examples of investor behavioural biases and how they can affect portfolios:

It can be difficult to overcome your natural instincts, but there are ways to mitigate their impact. The starting point is to understand your own motivations and behaviours. You can then build solutions into your investment plan to help maximise your chances of sticking to it – such as phasing in investments for additional comfort, or identifying specific triggers for action.

Managing uncertainty

In uncertain markets, it can be tempting to wait for better conditions before investing. However, another bias often comes into play here that can make us overly hesitant. The ‘availability heuristic’ is a mental shortcut that leads us to place more weight on dramatic events and data. It can lead investors to overly focus on short-term headlines and data, and pay less attention to longer-term market trends.

It can be even harder to take the plunge into investing when the macroeconomic outlook is worsening. With global growth widely expected to slow this year, holding cash may feel more comfortable, especially with the higher interest rates on offer. In the longer term, however, inflation can erode the real value of cash.

Sitting on the sidelines may also mean missing out on market returns. According to the Barclays Equity Gilt Study 2023, which looked at returns from UK asset classes between 1899-2022, the chances of equities outperforming cash over two years was 70%, and 91% over ten years. However, past performance is no guarantee of future returns.

Preparing for risk

Investing is inherently risky and unpredictable. However, holding a well-diversified portfolio, with a mix of assets, sectors and regions, can both mitigate the impact of unexpected events, and allow you to capitalise on them. Diversification can also help reduce portfolio volatility – and the emotional reactions it can trigger, which in turn can support clear, rational decision-making.

Investors could also consider hedging strategies, to protect against market risks while remaining invested. However, there are cost and potential performance considerations, so it’s important to understand the implications before putting any hedging in place.

Taking some risk is necessary to achieve returns above the risk-free rate. Over the long run, taking more risk typically leads to higher expected returns (as well as potentially higher losses). Investors have several choices in this respect:

1. Accept the risk as the price for pursuing higher long-term returns.
2. Invest in lower risk assets and accept lower expected returns. This may feel more comfortable, but is likely to reduce the chances of meeting your long-term goals.
3. Attempt to achieve higher returns for lower risk by trying to time the market. However, this is notoriously difficult, even for professional investors.

Finding opportunities

With growth in many economies expected to slow this year, the investment outlook today may feel uninspiring, perhaps worrying. However, it’s worth remembering that what matters more to investors is how markets – and their portfolio assets in particular – respond to both macro and microeconomic developments.

Investing is also more than just the markets – it’s about companies. High-quality businesses do not automatically stop being so because of a weaker macro backdrop, and good investment opportunities emerge throughout the cycle. It may be easier said than done, but investors should try to cut through the short-term noise and reflect on market events in relation to their own portfolios and long-term goals.

While past performance is no guide to the future, history reveals some recurring trends that may offer some comfort. Economies and markets tend to be cyclical, and investor sentiment oftens swings from between exuberance and fear. However, what drives growth over the long term are human innovation and technological advancement, and we expect this to continue into the future. From an emotional perspective, it may feel easier to invest in good times than bad, but it’s when market sentiment is extreme that the real opportunities tend to arise.

With much uncertainty on the macroeconomic and geopolitical front, the year ahead may be a volatile one for investors. However, focusing on time-tested investment principles, keeping your emotions in check, and your long-term goals in sight could help improve the chances of success.