Extreme market volatility is underlining the importance to investors of staying disciplined and avoiding damaging emotional mistakes.

Stock markets have experienced unprecedented swings this year, with share prices pinging up and down like a pinball in reaction to good and bad news around the Covid-19 pandemic, US elections, and energy market developments.

Despite optimistic stories about Covid vaccines over the last few weeks, the investment horizon is still extremely uncertain. Investors are nervous and vulnerable to the kind of damaging psychological errors that behavioural scientists have revealed to be common and highly costly. Now more than ever, they need to be wary of these mistakes.


Huge lifetime savings

Nobel prize-winning academics such as Daniel Kahneman and Richard Thaler have shown that deeply-embedded cognitive biases, such as herd mentality and overconfidence, drive most people’s investment decisions. Avoiding these mistakes can help individuals save thousands over the short-term and hundreds of thousands over their lives.

Studies have shown that they cost the average investor between 1% and 4% a year in returns. A 2% loss each year could mount up dramatically over 20 to 40 years saving into pensions and other vehicles. Unchecked, these errors could have a devastating impact on their retirement and other investment goals.

Advisory tool provider Edvoa has a calculator showing how this can impact investments over longer periods. For a £100,000 investment over 25 years, these biases would cost an investor £85,000 based on a 1% annual cost of errors; or £191,000 based on 2%.

Asset manager Vanguard looked at the impact for those investing £250 a month. For them, a 1.5% cost would lose them £24,000 over 20 years, or a painful £274,000 over 50 years.

Vanguard has also shown that helping clients avoid these errors is one of the main ways advisers and wealth managers can add value.


Avoiding herd mentality

Analysing market crashes is one way to demonstrate how these errors can impact investments in real life. In the 2008 to 2009 financial crisis, many investors were gripped by panic selling and sold out of shares. If they had done that at the lowest point of the crash in March 2009, they would have missed the subsequent ten years of growth, which was over 60%.

A similar thing happened this year, with the S&P 500 index of top US company share prices falling 34% in March from its earlier high, but then subsequently recovering a spectacular 62% to its current peak.

This time it all happened in the space of eight months, which demonstrates the increasingly dire potential consequences of errors such as knee-jerk responses, herd mentality, and panic selling. When market news grabs attention with huge highs and lows, there is a constant temptation to react irrationally.

Herd mentality is one of our most deeply ingrained cognitive tendencies. It can be a good thing – for example, choosing a good restaurant based on the number of local diners in it. But in the investment world, the tendency to follow a crowd can often lead investors to sell after a dramatic fall or buy after a spectacular rise – which are likely to be the worst times.

Some people make the sometimes equally damaging mistake of not investing at all due to fear of volatility, thus missing the better long-term returns that equities have usually provided throughout history.


Overcoming behavioural biases

There are many things you can do to avoid errors and biases and invest rationally. These include setting a trading strategy and sticking to it, for example, using trading rules such as stop loss orders. You can apply wider asset allocation rules that aim to keep your portfolio diversified; and you can employ an investment committee – or at least a second opinion – to test your investment processes and decisions. These all introduce a more systemised approach and reduce the role of emotion.

Our course Practical portfolio management – asset allocation and overcoming behavioural biases looks in-depth at psychological investing errors and how, as an adviser or wealth manager, you can help your clients avoid them.

It explains many of the main cognitive and emotional biases that scientists have identified. These include confirmation bias; herd mentality; gambler’s fallacy; negativity bias; loss aversion; hidden risk-seeking; overconfidence; and anchoring.

The course also looks at false perceptions of ‘safety’ through investing in large, domestic shares. It explains the attributes of each problem and shows how they can lead to significant misallocation of assets and increased portfolio risk.

This one-day programme reviews traditional portfolio theory against increasing evidence about which factors really drive investment returns. It helps delegates understand and explain common behavioural biases. And it shows how to spot them in clients and influence their decisions – for example, by measuring risk and reward carefully, brainstorming, and discussing perception versus logic and evidence.

The course also explores each bias through review and discussion of a client case study. This will enable delegates to spot similar issues in their client portfolios and help them discuss these matters with clients.
Delegates will also be asked to bring anonymous information about clients to allow a group analysis and discussion around real-life biases and misallocations. They will identify potential behavioural flaws and use role play to help build a client engagement plan they can take away and use.

Wealth managers know they can often face challenges in engaging with newer, naive or stubborn clients who are not open to understanding these issues. This portfolio management course can help them guide clients towards a more rational and profitable path.