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Be mindful of behavioural biases in volatile times

Paul Hennessy
— 1 minute read

Global markets and economies around the world, by and large, are now relatively acclimatised to the extraordinary conditions that the COVID-19 pandemic has presented. For now, at least. 

Paul Hennessy

But to imagine markets and economies have reached some sort of new equilibrium would be premature, as circumstances continue to evolve and markets and economies continue to search for their next phase of co-existence, post-pandemic.

The behaviour of financial markets in absorbing the initial shock and adjusting to the “new normal” (albeit one that remains fluid) has been volatile but arguably, relatively unpanicked. So far at least, their response has not been as severe as it was in the immediate aftermath of the global financial crisis (GFC). 

Meanwhile, economies around the world have been regulated by respective governments in their efforts to deal with the short-term policy implications of the immediate economic crisis while trying to comprehend and plan for the appropriate policy settings in the post-pandemic future. As the well-respected Australian business commentator Stephen Bartholomeusz recently noted: “All the talk about a return to normal after the pandemic – the debates about V-shaped or U-shaped, or W-shaped recoveries – understates the probability that whatever normal looks like after the pandemic, it won’t be what it was before.”

In this respect, for investors, understanding and anticipating behaviour are critical because it can often appear to defy all logic and reason. Why? According to research in behavioural finance, most investors are not strictly rational. Rather, they are subject to behavioural biases; past experiences, personal beliefs and preferences can influence judgment and skew decision-making. These biases can steer them away from logical, long-term thinking, and deter them from reaching their long-term investment goals.

Behavioural finance contends that when it comes to investing, people often exhibit herding behaviour or a “groupthink” mentality. They mimic the behaviour of others, especially in times of uncertainty. But the majority is not always right. 

Most investors are also loss averse. According to research by Nobel laureate Daniel Kahneman and his late collaborator Amos Tversky, losses hurt about 2-2.5 times more than gains satisfy. Put another way, the pain of losing US$10,000 is disproportionately greater than the pleasure of winning US$10,000; most people need a potential gain of around US$20,000-US$25,000 to balance the risk of losing US$10,000. 

This asymmetry can lead to panic selling during severe market setbacks. A litany of news stories (often negative) from around-the-clock news channels, the internet and social media can exacerbate investors’ emotions, making these behavioural biases even harder to overcome.





So, if behavioural biases can influence investment decisions, what is the potential impact on investment returns? We sought to answer this question by studying the effects of loss aversion and herding on investment returns. 

To be as comprehensive as possible, we analysed multiple scenarios using a loss aversion ratio of 2.5 times and covered a total of 337 rolling periods. For the purpose of this study, we focused on three scenarios: investors with high, moderate and low loss aversion, leading to high, moderate and low trading frequency respectively, which we compared with a buy-and-hold scenario. 

The results are striking. Buy-and-hold investors could earn better returns compared with those who move in and out of markets. 

Over the average 20-year rolling period between 1970 and 2019, an investor’s initial investment of US$100,000 would have had an ending value of US$755,609. By contrast, highly loss-averse investors would have gained US$648,858, or 15 per cent less. 

The bottom line: behavioural biases could lead to investors lagging their buy-and-hold counterparts and hinder the creation of long-term value. 

This is perhaps not entirely unexpected. Buying and holding investments for the long haul not only helps investors take advantage of the power of compounding, but it can also mean saving money on transaction fees and may offer tax benefits in certain countries. Choosing the right investments can make a big difference too.

Perhaps more importantly, these conclusions raise a bigger question: how can investors, given their behavioural biases, stay focused on their long-term investment goals? At Capital Group, we believe that portfolios with downside resilience and lower volatility can help protect investors from making irrational decisions. That is where skilled investment managers can add value. We believe investors should seek out strategies with a track record not only in up-markets but also down-markets. After all, for successful investing it is important to maintain a long-term perspective. Trying to figure out what the market will do today or even next week can be an impossible task and one that is all too often unhelpful in creating long-term wealth. 

Paul Hennessy, senior vice-president and managing director of Capital Group Australia

 

Be mindful of behavioural biases in volatile times
Paul Hennessy
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