How to Minimize the Impact of Irrationality and Investor Sentiment on Decision Making

People tend to think that Financial Planning is a one-way street and that Financial Advisors inform and guide their clients according to best practices, experience, and logic. While that is often true, it’s not always that simple, and nor is it always smooth sailing.

How Irrationality and Investor Sentiment Cloud Decision Making

Standard economic theory supports the idea that humans use infallible logic when making decisions; and that when we make wrong decisions, we quickly remedy them.

We all like to think this is true about us: after all, we’re rational, logical, smart …right?

Wrong! Behavioral economics has found that humans frequently act irrationally, and don’t realize our errors at all. Despite our very best efforts to try and think and act rationally, behavioural studies show how irrational our decisions often are. This means that Financial Advisors sometimes have an uphill battle to convince their clients that route A is better than route B; and mastering this battle requires a keen understanding of behavioral economics.

What is behavioral economics?

Behavioral economics began as a field of study in the 1970s and ’80s, but can be traced back to 18th-century economists. Behavioral economics combines psychology and economics to help explain why humans make economic decisions that are “not rational“ and to illuminate the difference between what people should do and what they often choose to do.

Here’s an example of the sort of behaviour that behavioural economists have found.

Meet Dave: Dave has two shares.

Which Share is Dave likelier to sell if he needs capital?

WHY? Dave’s subconscious tells him to aim for success by selling the winning share, rather than sell the losing share and admit he suffered a loss. Against his better judgment Dave says to himself; ‘’Share A could increase in value.”

According to Behavioral Economist & Author, Dan Ariely, we are not all rational and logical when it comes to investment decision making:  we continue making the same mistakes over and over—in fact we’re not only irrational but predictably so.

Many people hold inconsistent beliefs, illogical theories and personal biases: they often act impulsively, impatiently, and out of a sense of entitlement or need for instant gratification.

This sort of behaviour shows investors that despite their very best efforts to try and think rationally, they run the risk of behaving more irrationally than they’d like.

How to Minimize the Impact of Irrationality and Investor Sentiment on Decision Making.

It stands to reason that minimizing these impacts is crucial for making rational and objective investment choices.  Because you can’t predict how you’ll act in such circumstance, you have to work against irrational tendencies by creating natural guidelines toward rational decisions. One way to go about it is to find a Financial Advisor who you can trust to establish the following guidelines and help you make rational decisions based upon a clear plan.

1. Develop a well-defined investment plan: Create a clear investment plan that outlines your financial goals, risk tolerance, and the time horizon for your investments. Having a plan in place helps to maintain focus and reduces the likelihood of being swayed by short-term market sentiment or impulse.
2. Commit to a long-term perspective: Understand the importance of a long-term investment horizon and focus on the fundamentals of your investments rather than short-term market fluctuations. Remind yourself that market sentiment can be erratic and emotional, but a long-term view allows you to capture the potential growth of your investments.
3. Conduct thorough research and analysis: It’s best to rely on thorough research and analysis when making investment decisions. This includes evaluating the fundamentals of companies, analyzing industry trends, and assessing the broader economic landscape. By relying on data-driven analysis, investors can make more informed decisions rather than being swayed by short-term market sentiment.
4. Diversify your portfolio: A well-diversified portfolio can help reduce the impact of investor sentiment on decision-making. By spreading investments across different asset classes, sectors, and geographies, investors can mitigate the risk associated with any single investment. Diversification helps to smooth out the impact of market volatility and reduces the temptation to make impulsive decisions based on sentiment.
5. Set realistic expectations: We work hard to educate investors about the inherent volatility of financial markets and to set realistic expectations regarding investment returns. We emphasize that short-term market sentiment can be unpredictable and that staying focused on long-term goals is more likely to lead to successful outcomes.
6. Avoid herd mentality: We encourage investors to avoid following the crowd or succumbing to herd mentality. Just because others are buying or selling doesn’t mean it’s the right decision for their individual circumstances. Remind them that investing based on emotions or market trends can lead to suboptimal outcomes.
7. Stay informed but filter noise: Stay informed about market news and updates, but be cautious about overreacting to short-term information or noise. Make sure to rely on reliable sources of information and to consider a range of perspectives before making investment decisions. This helps to avoid knee-jerk reactions based on fleeting market sentiment.
8. Seek professional advice: Engaging a financial advisor can provide valuable guidance and an objective perspective. A professional advisor can help investors navigate market sentiment, keep emotions in check, and offer expert advice based on their experience and knowledge.
9. Regularly review and rebalance: Regularly review your investment portfolio to ensure it remains aligned with your investment plan and long-term objectives. Rebalancing allows for adjustments in asset allocation based on changing market conditions, without being influenced solely by short-term sentiment.
10. Test, test, and retest your thinking: Regularly subject your decision making to the rationality test. Ask yourself “Is this what I should be doing, or is this what I want to do?” Involve your financial advisor in your decision making: two heads are invariably better than one and you will benefit from your advisor’s impartiality and objectivity.

Minimizing the impact of investor sentiment on decision-making requires discipline, patience, and a commitment to long-term goals. By focusing on sound investment principles, conducting thorough research, and staying disciplined, investors can reduce the likelihood of making decisions based on emotional or irrational factors.

Behavioral Guidance and Emotional Support:

At WestStar we make it our business to provide behavioral guidance and emotional support to help clients navigate market fluctuations, avoid emotional decision-making, and maintain a long-term perspective. We offer reassurance during market downturns, and help clients to stay committed to their investment strategies.

If you have questions about your specific circumstances, or want to make sure you’re equipped with the guidance and advice to pursue your future with real confidence and clarity, please get in touch. I welcome the opportunity to chat with you.

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I wish you every success in the future and hope to hear from you soon.

Serge Suleimani

Disclosures:

“A diversified portfolio does not assure a profit or protect against loss in a declining market.”

“Re-balancing may be a taxable event. Before you take any specific action be sure to consult with your tax professional.”