The psychology of investing

“Losses loom larger than gains”

When we look at the news headlines, we often see updates covering inflation, recession, conflict, civil unrest, interest rates…the list could extend for paragraphs.

It is therefore natural for us to be concerned about our savings and investments, given the challenges we face in any given period.

During periods of volatility it can seem reasonable in our minds to want to remove any risk from our investments and move it to cash until things improve. With investing, this may not be the rational decision to make, as this is the point in time we must be most disciplined with our investment processes to ensure we are still operating with our goals in mind.

To explain this we will explore a concept called loss aversion, first described by Kahneman and Tversky’s study of prospect theory in the 1970s. Loss aversion in investing refers to the psychological phenomenon where investors are twice as sensitive to the pain of losing money than to the pleasure of gaining an equal amount. This often leads to irrational decision-making, particularly in response to market downturns.

The part of our mind that processes losses, is the same part that processes fear, which can lead to us making decisions driven by emotion, rather than based on a rational analysis of the investment’s long-term prospects.

Past performance is not a reliable indicator of future results.

It’s impossible to time the market. No one is going to ring a bell and tell us when markets are going to drop or when they’re going to rebound.

To demonstrate the impact your decisions will have on your investments, let’s look at two examples.

Investor A, represented by the purple line on the chart above, invested £200,000 in 1999 and left it invested in a simple 60% Stocks and 40% Bonds portfolio. Over that time they reviewed their value once a year and never made any changes. Today that portfolio has more than quadrupled in value and is worth over £800,000.

Investor B also invested £200,000 in 1999 in the same portfolio. However, Investor B checked their value daily and therefore watched their values go up and down daily. For this example, we have excluded the ten days with the highest positive market movement. Over the past 24 years all of the ten best trading days have followed market drops. Although Investor B missed just ten days, the long-term impact is dramatic.

We can see from the chart that Investor A is now over £200,000 better off than Investor B. By missing 0.1% days, Investor B has missed over 20% of the potential growth.

By reacting to a fall in markets, Investor B disinvested on the ten best days for market performance – potentially forgetting that the markets can act like a pendulum, swinging back and forth. They may have allowed their investment strategy to be driven by emotion and fear, rather than sticking to their long-term plan.

Past performance is not a reliable indicator of future results.

The table above illustrates the daily returns of the portfolio that investors A and B are both invested in.

Investor B, who was checking their investments each day, would have experienced every up and down on this chart. However, we know the downside days will have had double the psychological impact than the positive ones.

Over the long-term, the number of days that are positive are roughly equal to the number of days that are negative. For someone looking at it every day it is a flip of a coin whether they will be up or down. If we consider that the positive days only give you half the joy relative to the amount of pain negative days will, investor B was more likely to be an extremely unhappy person.

Past performance is not a reliable indicator of future results.

This is the same portfolio that Investor A and B are invested in, but we are now looking at the one year rolling figure.

Let’s consider Investor A who reviews their investments once a year. Those 50/50 odds from the daily returns view are now 80% positive vs 20% negative when viewed yearly. This is how growth is generated over the longer term.

For every two negative years, we have had eight positive years. Investor A recognised this, and when markets were unsettled they stuck to their guns and didn’t try and time the market. Investor A endured the more challenging periods, and reaped the benefits when markets recovered.

Past performance is not a reliable indicator of future results.

If we take the chart on a five year rolling basis, we can see that the positive returns have significantly shifted even more to 96% of the time.

Over the past 24 years, unless you invested at the peak of the market of the dotcom bubble, you would have generated positive returns over five years. Through the financial crisis and through Covid-19 you would still be positive had you remained invested for five or more years.

Not every year is going to be positive, we must understand that. If we look back over history, the events that have upset markets the most are the events that were a surprise. No one (or very few people) knew about them before the event happened.

It’s easy in hindsight to tell ourselves “we saw it coming, we should have done x,y,z” but in reality, everyone is on the same boat and no one will tell us what is over the horizon.

Hopefully, these charts highlight the risks of trying to time the market. The odds tell us all we need to know as we increase the period we look back over – from 50% positive on a daily basis to 80% positive yearly and even 96% over five years.

This shows us that to generate potential long-term returns, we should typically avoid making short-term shifts of investment strategies to disinvest and reinvest, other than when your overall attitude or capacity for investment risk changes.

In terms of the psychology behind investing, these examples demonstrate how easy it can be to be influenced by market performance.

We can see that if investors are willing to take investment risk, remain disciplined and not allow decisions to be driven by fear and short-term volatility, it allows investors more opportunity to grow their wealth over the long-term.

This publication is not personal financial advice or a recommendation. If you are considering changing your investment strategy, it is important to get personal advice from a qualified financial adviser.

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. This material is not a personal recommendation or financial advice and the investments referred to may not be suitable for all investors.

Past performance is not a reliable indicator of future results.

True Potential Wealth Management is authorised and regulated by the Financial Conduct Authority. FRN 529810. Registered in England and Wales as a Limited Liability Partnership No. OC356611.

True Potential Investments LLP is authorised and regulated by the Financial Conduct Authority. FRN 527444. Registered in England and Wales as a Limited Liability Partnership No. OC356027.

True Potential LLP is registered in England and Wales as a Limited Liability Partnership No. OC380771.