Behavioral finance and the virtue of long-term perspective
While quantitative analysis is increasingly prevalent for investors, the ability to understand market cycles driven in part by the emotions of market actors, is a critical part of any investment strategy.
Market actors have become increasingly reliant on quantitative analysis – to the point that many investors, such as quantitative hedge funds, are driven almost solely by algorithms. Successful stories abound in the finance community of some quant funds delivering top-notch performance. But ultimately, these algorithms are not – contrary to what many believe – focused on a better understanding of the underlying assets. They aim at understanding better the behavior of market actors in the context of certain operating and financial performance factors, rather than relying on the dry data-driven analysis of the underlying assets.
Investors are humans, with their own views, objectives and perceptions. Financial markets’ behavior arises from the consequences of the myriads of individual choices made by the myriads of investors and market actors. While finance theories like valuation methodologies are based on core principles including the rationality of investors, human investors do not always act rationally in reality. And the multiple decisions taken by human investors can end up being particularly complex to observe or understand, and even beyond the cognitive ability of an individual to fully comprehend.
The field of academic study called Behavioral Finance has been developed to better understand the influences and biases affecting the behaviors of investors, and assess these biases as potential explanations for market anomalies.
One of the best known anomalies in the stock market is the recurring phenomenon of bull and bear markets, with valuations increasing then receding, before increasing again a while later. In the 61-year period from 1957 – when the S&P 500 started to have 500 stocks in the index – to 2018, the average return of the index was roughly 8% (source). However, the annual returns varied significantly from negative to positive in recurring cycles of “boom and bust”.
One of the underlying reasons behind such cycles is the perception of the future that investors and market actors have at a given time, commonly known as the “Cycle of Market Emotions”. When facing exceptional situations, humans follow patterns of behavior, and investors – even the most rationale ones - are not that different, exhibiting predictable behaviors, thereby amplifying upward and downward market evolutions.
Emotions can drive investors to buy stocks too late or too early, or sell too late or too early, thereby reducing their potential investment gains or magnifying their potential losses. Cognitive biases held by investors can translate in selling share of the best companies too early or holding on losers for too long, thereby generating sub-par returns.
Wealth management clients tend to have a longer-term approach in their investment strategies, taking the perspective of long-term wealth creation through balanced allocation of capital across cycles. Through the design of a structured approach customized for their needs and aiming at benefiting from long-term value creation, private bankers can help clients manage through the market’s cycles of boom and bust.