Understanding Investor Behaviour: Are You a Good or Bad Investor?

Investing in the stock market can be a thrilling activity, and it comes with the potential for great rewards. However, your success as an investor can hinge on your emotions and decisions – on what is called investor behaviour.

Researchers have found strong connections between social, emotional and cognitive factors that affect human investing decisions and the subsequent financial outcomes. In this article, we will dive into the attitudes and behaviours of good and bad investors, share the contrasting impact these behaviours have on portfolio outcomes, and show you how to be a better investor.

What is Investor Behavior?

As financial advisors, we are super alert to different kinds of investment behaviour! Why? Well, it turns out that research in the field of behavioural finance has shown that people tend to make some pretty irrational investment decisions.

There’s a connection between our emotions and the crazy twists and turns of the market. Moreover, there are different types of investor behaviour out there, which cause people to make specific choices when it comes to their investments. Investor behaviour is based on how we respond to uncertainty, to the different news reports or opinions we hear, or to trends in the market. Each person’s individual comfort with taking risks, and their ability to emotionally handle losses or investment returns, are often the factors that determine our response.

So why is this good or bad? Let’s dig into these different types of investor behaviours and find out.

The Emotions of Investor Behaviour

The psychology behind investor behaviour and investor emotions is fascinating. Just like the ups and downs of the market, our emotions mirror those fluctuations. It’s crucial to grasp how powerful our emotions are in driving our response to situations, particularly financial ones.

As we journey through a market cycle, we will encounter a range of emotions that can affect our actions and therefore, our portfolio. 

A study conducted by DALBAR, an independent financial research firm, revealed that the average investor will often perform worse than the overall market.

From 1999 to 2018, the S&P 500 index had an average yearly return of 5.62%, while the average investor only achieved a 1.71% return!

This shocking performance gap can be largely attributed to emotional decision-making and behavioural biases.

DALBAR walks us through the market cycle and our corresponding emotions. During the early stages of investing, investors often experience optimism, excitement, and even euphoria. As the market fluctuates, investor emotions become increasingly positive when returns are high and feelings of euphoria peak.

Then, when the market inevitably experiences a decline and investments lose value, uncertainty can lead to feelings of nervousness and anxiety. Will the market continue to fall or will it recover?

At this stage, investors may start to panic. They become their own worst enemies by losing sight of their long-term investment objectives and selling their stocks hastily to avoid losing even more. This impulsive behaviour results in significant losses for their portfolios when the market rebounds.

When the market rebounds, these investors regain confidence in their long-term investment strategy. However, prolonged volatility or an ongoing downward trend may cause increasing fear of losses and uncertainty about the market’s future.

(A Quantitative Analysis of Investor Behaviour Conducted by DALBAR Inc. in 2008)

The DALBAR Study also discovered that many active investors had an average holding period of just over 3 years. Why? Because these changing emotions are misleading, with investors making poor decisions based on fear and loss aversion, or even a belief that they can ‘time the market’. As a result, they may hastily sell their portfolios when their investments are worth the least.

This is why so many Australian investors consistently achieve lower returns than the market average.

So what do you do when you hear bad news? Or when the market declines due to global events beyond your control? The more awareness an individual investor has about their emotional responses, the more able they will be to overcome their cognitive biases and respond rationally to changes in the stock market.

FAQ: Should I sell when the market drops?

It’s important to avoid panic selling when the market experiences a drop.

Instead, staying invested for the long term can be more beneficial for you and your portfolio. Selling hastily during a bear market can lead to much lower returns, and there are several reasons why it’s wiser for investors to hold on to their investments. If your portfolio is well-diversified, you shouldn’t need to panic or worry. However, if you are investing with individual companies, it is wise to periodically review their financial statements to ensure that they continue to be financially stable even during a downturn.

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Case Study: The DotCom Bubble

Let’s use the DotCom Bubble as an example.

The Dotcom Bubble occurred during the late 1990s when there was a speculative frenzy in internet-based companies’ stocks. Many investors were drawn to invest in technology and dotcom-related stocks, leading to a significant market bubble. However, this bubble eventually burst in the early 2000s, resulting in a severe market decline and a subsequent recession.

During the bubble’s heyday, many investors made emotional decisions. They bought overvalued technology stocks because of the euphoria of the dot-com boom. Then they sold at a loss when the market collapsed.

The DALBAR study investigated the behaviour of investors during this time, and the results highlighted the impact of emotional decision-making and its consequences on investment performance.

The main takeaway from the DALBAR study is that emotional investing and attempting to time the market are usually detrimental to investors’ long-term financial success.

Investors who make decisions based on fear and greed during market booms and busts tend to underperform the market over time. 

What is Smart Investor Behaviour?

So we’ve looked at the emotional response we can have by investing in the stock market. Now, let’s look at how we can combat those natural feelings and cultivate smarter investor behaviours.

Good financial behaviour involves making informed and strategic decisions with a focus on achieving long-term financial goals. 

To be a smart and rational investor, practice the below attitudes to your financial investments, while understanding your personal sensitivity to risk and your long-term goals. 

• Patience: Good investors understand that investing is a long game. They resist the urge to make impulsive decisions based on short-term market fluctuations and focus on the overall performance of their investments over time.
• Discipline: Good investors have a well-defined investment strategy and stick to it. They avoid chasing hot investment trends and remain committed to their long-term goals, even during periods of market volatility.
• Diversification: Good investors understand the importance of diversifying their investment portfolios. They spread their investments across different asset classes, industries, real estate and geographic regions to mitigate risk and capitalise on potential opportunities.
• Research: Good investors conduct thorough research before making investment decisions or seeking experts’ help. They analyse financial statements, market trends, and economic indicators to make informed choices. They also stay updated on relevant news and developments that may impact their investments.
• Rationality: Good investors base their decisions on rational analysis rather than emotions. They are not swayed by market hype or fear-driven selling. Instead, they maintain a logical and objective approach, considering all available information.

What is Bad Investor Behaviour?

Bad investor behaviour is allowing emotions to guide decision-making.

These emotions might be fear or alarm, but they can also be ego-driven, like over-confidence or the belief that one’s gut is always right. 

• Impatience: Bad investors often seek quick profits and engage in excessive trading. They constantly buy and sell investments based on short-term market movements, which can lead to high transaction costs and undermine long-term gains.
• Emotional Decision-making: Bad investors are prone to making impulsive decisions driven by fear or greed. They panic and sell during market downturns or chase after high-flying stocks without proper analysis.
• Loss Aversion: Bad investors are likely to be loss averse, a common cognitive bias where people fear losses more than they enjoy equivalent gains. This fear drives bad investors to make irrational decisions to avoid potential losses, impacting their overall investment strategy.
• Overconfidence: Bad investors may exhibit overconfidence in their abilities, leading them to take excessive risks or concentrate their investments on a single asset or sector. This lack of diversification exposes them to heightened volatility and potential losses.
• Herd Mentality: Bad investors often follow the crowd and make investment decisions based on the actions of others. They may buy when the market is euphoric and sell when fear grips the market, thereby buying high and selling low.
• Lack of Research: Bad investors may overlook the importance of thorough research and due diligence into companies. This can be particularly true of trending stocks that are getting a lot of hype. Relying on tips, rumours, or hearsay without verifying the information increases the risk of poor investment decisions.

Getting A Financial Advisor Perspective: Hayden Boglary

Experienced finance advisors can help investors avoid these pitfalls by providing the research, analysis, and objectivity to make informed investment decisions. They can also help investors develop a sound investment strategy that is tailored to their individual needs and goals. Hayden Boglary, one of our advisers, provided his thoughts on good and bad financial behaviour and its relation to stock returns.

I’ve been investing for a few years now, and I’ve seen it happen to myself and to our clients. I’ve learned that emotional bias can be a major obstacle to making sound investment decisions.

When the market is down, it’s easy to get scared and sell your investments, even if you know they’re good long-term bets. And when the market is up, it’s easy to get greedy and buy investments that you don’t fully understand.

Emotional bias can cause investors to make suboptimal decisions and this bias can be difficult for an individual investor to identify and correct.

Often bad investor attitudes can lead to destructive behaviours that limit investors from achieving their financial goals. Unfortunately, rationality is frequently not the primary driver of our decision-making process as human intellect is often subservient to human emotion during this process. 

Engaging in decision-making influenced by emotional reactions to negative economic news or headlines about recessions is ultimately an unsuccessful endeavour.  Trying to time the market during its ups and downs is extremely risky and research has shown over the long term this strategy leads to poorer market returns.

For example, 7 out of the 10 best-performing market days in the past 20 years (using the S&P 500 Index as a representation of the stock market) occurred within a two-week timeframe following the market’s largest one-day declines!

Even if you manage to time one of these turnarounds, it is not possible to accurately time them all. Missing these turnarounds has been costly, as we can see in the graph below.

Sources: Ned Davis Research, Morningstar, and Hartford Funds, 2/23.

If an investor has a defensive stance or responds emotionally to market movements, they are also more likely to follow the actions of others in a herd mentality. It is this response which can amplify market movements or false trends, and cause unnecessary fear in the market.

On the other hand, the opposite can happen during a bull market; if investors become euphoric this can lead to excessive optimism and cause markets to become overvalued giving rise to market bubbles. 

As a financial advisor, I work with clients to overcome emotionally driven financial decisions, thereby mitigating the risk of bad investor behaviour and enabling them to see consistent long-term growth.

We play a crucial role in developing effective investment strategies based on objective research and analysis. This removes behavioural bias from the decision-making process, which is vital to achieving the client’s financial goals.

Combining a consistent investment strategy with patience will allow compounding growth and time to do the work for you.

Conclusion

In a nutshell, understanding investor behaviour is essential for successful investing. The DALBAR research sheds light on how emotional decision-making and behavioural biases can cause underperformance.

That’s where the guidance of financial experts and a disciplined approach come into play. By being self-aware, and tapping into professional advice, investors can make informed decisions that yield better long-term results. So, stay active, stay savvy and seek guidance.

At My Wealth Solutions, our expert financial advisors use the C.A.R.E. investment approach to create a sustainable and diversified investment structure for our clients. 

To put it simply, the C.A.R.E. Investment Philosophy is:

• Designed to weather any market fluctuations
• Aimed at growing your wealth for the long term
• Designed to grant you the peace of mind that comes from knowing your financial future is secure
• Overseen by a team of expert Australian financial professionals with over a century’s worth of combined experience.

By understanding our clients’ behavioural patterns or investing attitudes, financial advisors can provide more personalised advice. Of course, this helps strengthen the advisor-client relationship but also improves the overall quality of investment advice advisors can offer clients.

If you’re interested in speaking with one of our financial advisors about a personalised investment strategy, book a free consultation today. 

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