The coronavirus pandemic and Ukraine crisis have given rise to extremely marked fluctuations on the stock markets and thus provided the best possible illustrative material for the topic of “behavioural finance”. “Behavioural financial market theory” works on the assumption that events on the financial markets are not perfectly efficient. In other words, not all relevant and available information is priced in at all times. Instead, prices are influenced by the irrational behaviour of investors. Emotions such as fear, euphoria and even greed inhibit investors’ ability to make rational decisions, leading to price distortions.

In order to make investing more rational, it is worth thinking about how investments come about and what errors are made on a regular basis. Since its emergence in the 1980s, behavioural finance has identified numerous unfavourable behaviours. We explain the most striking examples below.

The most common pitfalls of investing:

Loss aversion
You hold two equities in your portfolio. While one is CHF 100 down, the other is up by the same amount. Both are worth CHF 1,000. You urgently require precisely this sum of money. Which equity do you sell – the loser or the winner?

Studies show that most investors will tend to opt for the latter, thus depriving themselves of future returns. They have a tendency to take profits too early and limit their losses too late.

Anchor points
In many instances, the cost price at which an investor personally acquired an equity is used as an anchor point that acts as a basis for deciding when to sell the security. This is highly irrational, as the future performance of the security does not depend on whether it is up or down at the present time.

Herd instinct
Everyone is familiar with the image of lemmings blindly following each other as they fall into the abyss together. In the financial world, herd behaviour manifests itself as follows: Investors purchase securities that have performed well rather than those that have fallen sharply and are thus favourably priced. Trends are reinforced by a “fear of missing out” (FOMO) – as regularly seen in the run on cryptocurrencies or the dot-com bubble.

Confirmation bias
When making investment decisions, people tend only to pay heed to the information that supports their own assessment and ignore the views of others. Example: If a Rolex collector allows their fondness for the watch designer to cloud their judgement of an investment’s outlook, they may fail to take account of the potential risks posed by the equity.

Hubris
According to studies, when making investment decisions, it is not uncommon for investors to place an excessive focus on the industry in which they work themselves. However, while a doctor, for example, may be familiar with the healthcare sector, this doesn’t necessarily make them a successful pharmaceutical investor.

Gambler’s fallacy
If you choose black five times when playing roulette, most people assume that the ball will fall on red the next time the wheel is spun. This effect is based on the idea that the ball will fall on red as often as it does on black. In truth, however, each game is completely new and what has gone before has no bearing on the colour on which the ball lands. In other words, after every spin, there is just as much chance that the ball will end up on red as there is on black the next time it is thrown onto the wheel. It is exactly the same with equities: If a security posts a loss one day, this doesn’t mean that it will increase in value on the following day.

It is not easy to fight deep-seated behavioural patterns that frequently send us in the wrong direction. Just knowing this helps. Those who know themselves and are critical and honest with themselves have the better cards when it comes to investing.

Investment advice plays a key role in countering the inefficiency of the financial markets. For example, our clients are made aware of the topic of behavioural finance and informed about potential behavioural errors. Expert, independent advice that looks at the situation in a level-headed manner and from a distance is essential for achieving investment success.

Behavioural financial market theory helps asset management providers to optimise performance. With us, it even directly influences the investment process: As markets are not perfectly efficient, active management can generate added value over a passive investment solution.

In keeping with our investment philosophy of “security over return”, objectively defined criteria that are determined in advance are applied in order to prevent behavioural errors. For example, our risk management intervenes to prevent loss aversion among investors: If a security loses too much value, the position is reduced or even sold after being reviewed once more. This disciplined risk management means that risks are not minimised on a general basis, but rather managed in a targeted manner.

The “Defensive Growth” investment strategy has also proven its worth, generating a higher return over the long term than cyclical and more volatile securities. In our selection process, we therefore focus on high-quality companies that exhibit sustainable profitability and stable growth.

Learn more about our services and competencies. Our client advisors look forward to hearing from you!

This publication is intended exclusively for information and marketing purposes. It does not represent investment advice or an individual, specific investment recommendation. It does not constitute a sales prospectus and shall not be construed as a solicitation, offer or recommendation to purchase or sell any investment instruments or services or to engage in any other transaction. Maerki Baumann & Co. AG does not provide any legal or tax advice and recommends that investors seek independent legal or tax advice with respect to the suitability of such investments, as the tax treatment depends on the client’s personal circumstances and may be subject to constant change. Maerki Baumann & Co. AG is the holder of the Swiss banking licence granted by the Swiss Financial Market Supervisory Authority (FINMA).

Editorial deadline: August 2022