How understanding our psychology could help when investing

As an investor, thinking about how our minds work can be really valuable. It can give us insight into our reactions and the impact our decisions can have when trying to get the most out of our investments over a period of time.

STAYING FOCUSED ON THE LONGER-TERM PROSPECTS

Anna says, "From a psychological perspective, during times of change, our first instinct can be to seek to resolve discomfort above all else. When you have experienced loss, you may act to take back control and dispel the uncomfortable feelings. Or you might look to avoid further loss.

"The power of this moment can make it hard for you to think about the longer-term prospects and what this means for your financial goals years from now. You can think of this as being psychologically short-sighted."

For investing that can be particularly important. Coutts Chief Investment Officer Alan Higgins explains how the trees can often obscure the wood. "The media might report a drop in a certain stock today but they don't report the 100%+ returns you would have seen in the FTSE 100 in the 20 years from 2001," he says. "That second fact isn't 'news' – but it's still true." 

"Understanding our psychology can also help us better engage with markets. In the last 10 years the S&P 500 returned an average of 12.39% a year (before fees or charges) according to Business Insider, Aug 2023. But what's really important is knowing that you would have only achieved growth like that by staying invested for the full 10 years. If you'd taken your money out of the market before you planned to, perhaps after a particularly bad year, you might have crystallised a loss," says Alan.

KEEPING YOUR LONG-TERM 'COOL'

Behavioural Science Lead, Ed Nottingham, explains that exiting with a loss might feel like the right thing to do to 'save' your money, "but if the plan is to invest for the long term then a panicked 'hot' reaction could jeopardise your long-term 'cool' and practical plan".

But of course, the science tells us that people react differently. "Some people are much more anxious in the face of market uncertainty and are more prone to underinvestment, or even panic selling," says Ed. "Others have a stronger tendency to overconfidence, over-trading, or just following the trend.

"A practical plan can keep you focused on your long-term goals throughout and not distracted by reaction instincts."

Because our emotions are reactionary, they're naturally behind the economic cycle. By exiting during volatility the only thing you might be doing is guaranteeing a loss. Then, when markets recover, you'll need to pay a higher price to buy back in or come back in with a smaller portfolio. Over a long-term period that could significantly harm the potential for growth. This is why Alan and his team often suggest that clients with a long-term horizon goal stay invested for at least five years to see through the volatility. Then, if you've been in the market throughout, you really could have a portfolio that averages out to have comparatively robust returns.

WHY IS STOCK-PICKING SO RISKY?

Looking at certain stocks and placing bets on them, especially if they have done well and are making the news, can feel tempting, but again this could represent a 'hot', emotional, reaction. Firstly, single stocks carry much more risk and, secondly, you could be missing out on the benefits of diversity.

"My own grandfather, who himself worked in finance, would make selective investments but he didn't feel confident in investing in new sectors," says Ed. "We all tend to prefer things familiar to us, but this familiarity bias can be problematic. By focusing on sectors and regions he knew first hand, my grandfather missed out on high growth that new sectors saw."

By planning a diversified portfolio and leaving it for as long as possible, you could capture growth from a range of sectors, locations and assets while potentially limiting the risk of being over exposed to one sector. "We emphasise to clients that we'll focus on the day-to-day by monitoring markets and data trends and adjusting your diversified portfolio accordingly for optimisation," says Alan. "This can help you stay focused on the long-term picture."