Changing perspectives: From emotional trades to efficient portfolios

Making sound investment decisions is easier said than done. Consider this common dilemma: should you sell a stock after a substantial price increase to lock in profits, or hold on to it in hopes of even higher returns?

Victims of their own psyches

As the adage goes, "It's tough to make predictions, especially about the future." This rings especially true for investors. The inherent uncertainty of the future often leads to decision-making that is skewed by bias. Behavioural finance - a field dedicated to understanding how emotions influence investing - has identified several psychological inclinations that can lead to poor investment decisions. 

Fear, greed and the herd mentality

One frequent bias is herd behaviour, or in other words, the tendency to follow the crowd. When everyone is buying, the fear of missing out can propel investors into overvalued markets, or compel them to sell at rock-bottom prices when panic sets in. Equally dangerous is the overconfidence bias, or believing too strongly in one's own judgment, which can lead investors to underestimate risks. 

Research has shown that the fear of losing money weighs more heavily on people than the pleasure of an equivalent gain. This loss aversion bias often results in investors selling too early during an upswing or holding on too long during a downturn, as they hope against hope for a rebound.

Forecasting through analysis

Although it's impossible to totally eliminate uncertainty, robust price projections can help navigate these biases. The two most widely used methods for doing this are fundamental analysis and technical analysis.

Fundamental analysis involves examining a company's financial statements, industry trends and market conditions in detail to determine a stock's intrinsic value. Value investors, for instance, try to identify stocks trading below this intrinsic value as they believe the market will eventually correct the mispricing.

Rather than delving into financial statements, technical analysts focus on historical price and volume data. They operate under the premise that all relevant information is already reflected in the share price. By analysing price charts, they aim to identify trends and predict future price developments - a method that's particularly popular with investors who take a short-term view.

A revolutionary shift: Modern portfolio theory

The aim of fundamental and technical analyses is to make better decisions when buying and selling individual securities. An alternative approach, which instead takes a broader view and focuses on overall portofolios, is modern portfolio theory (MPT). Developed in the 1950s by Nobel Prize laureate Harry Markowitz and other economists, MPT posits that a well-diversified portfolio can reduce risk without sacrificing expected returns. Markowitz demonstrated that using mathematical methods, it's possible to construct an “efficient portfolio” that maximises returns for a given level of risk - or minimises risk for a given level of return.

Implementing modern portfolio theory

The insights gained from MPT led to a paradigm shift: away from the fixation on buying and selling individual securities and towards systematic portfolio management. This approach, which has since become a cornerstone of portfolio management, consists of three key steps:

1. Assessing the risk profile: This requires determining how much risk an investor is both willing and able to take by evaluating factors such as the investment horizon, personal circumstances and financial commitments. It's also important to consider their return expectations.
2. Developing a long-term investment strategy: This involves ensuring that the risk profile informs the long-term allocation of assets across various asset classes, sectors, regions and countries. Research indicates that asset allocation can account for 70 % to 80 % of long-term investment performance. Generally, if an investor can and is willing to take on more risk, then a greater allocation to volatile investments with higher return potential is justified.
3. Constructing an efficient portfolio: This requires selecting a mix of investment instruments - such as individual equities, bonds, ETFs, structured products, precious metals or even cryptocurrencies - in such a manner that their returns are as uncorrelated as possible. This helps to offset losses in one segment with gains in another.

Rebalancing and tactical adjustments

But constructing an efficient portfolio is only the first step. As market conditions evolve, periodic adjustments need to be made to maintain alignment with the long-term strategy. This is called rebalancing, and involves restoring the targeted asset allocation - buying equities and selling bonds, for example - when market movements cause deviations. Additionally, tactical adjustments may be warranted if, after careful analysis, the investor believes a market downturn is an overreaction. If that's the case, temporarily increasing their equity exposure might enable them to capitalise on an anticipated recovery.

The art and science of investment

Modern portfolio theory has paved the way for a more systematic approach to investing, underscoring the importance of a robust investment strategy. Implementing such a strategy in a disciplined way can also help investors overcome emotional biases and avoid costly mistakes. While selecting and timing individual securities remains important, the best defence against market volatility is a well-diversified portfolio - paired with an awareness of the psychological pitfalls inherent in investing.