If you ever walked down the road and suddenly saw a large group of people running the other way, shouting in fear, you would very likely turn on your heels and follow the crowd before you knew why.
This is because our brains have evolved to react to certain situations instantly to help us survive in the wild. This group of instinctive behaviours is broadly categorised as “psychological biases”.
The bias used in this example is known as “herding”, and it can be very useful for blending in with a larger group to avoid predators or to escape from dangerous situations, such as fires.
However, when it comes to less dramatic circumstances that require a more measured approach, our brains often still react instinctively, which can be detrimental to longer-term outcomes.
Investing is an area that is particularly affected by psychological biases. So much so that there is an identifiable “behaviour gap” between the returns you get and the ones you could have had if you hadn’t been led by your biases.
Read on to find out about the behaviour gap and how financial planning can help you bridge it.
The human brain experiences financial losses as pain
Research reported by University College London shows that financial losses activate many of the same neural pathways as physical pain. So, when markets fall and your investments drop, your reaction is likely to be driven by instinct rather than reason.
The instinctive response to pain is to move away from whatever is causing it. When it comes to investment losses, that can mean selling off and exiting the market.
However, selling during downturns can lock in your losses and mean you miss out on the recovery that typically follows dips.
Indeed, Schroders found that investors who exited the market amid every significant downturn since the late nineteenth century faced longer recovery periods than those who remained invested throughout.
So, while volatility may trigger a strong emotional response, successful investing often depends on resisting your short-term instincts and focusing on long-term growth and discipline.
Following the herd doesn’t typically lead to long-term results
Just as market downturns can tempt you to sell, herd mentality can cause you to follow the crowd to whatever has performed best most recently.
When a particular stock or sector delivers strong returns, it is natural to feel drawn towards it. However, research shows that chasing high performers rarely leads to better long-term outcomes.
Further research by Schroders found that between 2005 and 2022, in 12 of the 18 years, none of the 10 best-performing US stocks in one year remained in the top 10 the following year. On average, only 15 companies managed to stay within the top 100 performers for two consecutive years, so investing in a high performer often means losing out shortly after.
The evidence suggests that very strong performance is often temporary. So, it’s typically a good idea to build a strategy for long-term sustainable progress, rather than chasing short-term highs.
Following your biases can result in a behaviour gap
Emotional reactions to market movements can lead you to make decisions that feel right in the moment but have detrimental long-term outcomes.
The difference between returns unaffected by emotional biases and those affected by them is known as the “behaviour gap”.
Research from Barclays found that the behaviour gap leads the average investor to miss out on around 15% of potential returns over a decade.
As such, it’s important to try to remain disciplined and avoid emotionally driven decisions when investing, and to recognise that short-term volatility is a normal part of long-term market growth.
Financial planning can help you bridge the behaviour gap
A financial planner can’t override your instincts, but they can help you build a structure that encourages more considered decision-making.
By taking the time to understand your situation, a financial planner can help you build a plan centred on your life goals rather than the latest market movements.
They can also work with you to diversify your portfolio to help smooth fluctuations on your path to long-term growth. And when your old biases kick in, a financial planner can provide a valuable perspective based on evidence and their experience, rather than survival instincts.
To speak to a financial planner, get in touch.
Email us at hello@vwmwealth.com or call us on 0141 229 4004.
Please note
This article is for general information only and does not constitute advice. The information is aimed at individuals only.
All information is correct at the time of writing and is subject to change in the future.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
