Understanding Behavioral Finance: Staying the Course in Volatile Markets

At Northwood Family Office, we believe in the long-term, conservative stewardship of wealth. We have a proven track record of navigating the complexities of financial markets and consistently earning the trust of our clients. An integral part of our philosophy, and one of the reasons we have been able to earn that trust, is understanding and mitigating the behavioral biases that can lead to irrational investment decisions, especially during periods of market volatility.

I’m a senior associate in the client advisory team and have been with Northwood for just over three years now. I studied finance and have completed my CFA designation, but I’ve always been passionate about the connection between psychology and finance/investing. I believe that our experiences and mindsets play a significant role in shaping our financial behaviors and decisions and, so, I’m curious about the various biases that can affect my clients, who come from diverse backgrounds. At Northwood, our goal is to help our clients achieve their objectives by managing the complexities of their financial lives. While serving in my senior associate role, I am also committed to understanding and helping clients navigate the behavioral aspects of finance.

The Impact of Behavioral Finance on Investing

Behavioral finance studies the psychological influences and biases that affect the financial behaviors of investors. Unlike traditional finance, which assumes that investors are rational, and markets are efficient, behavioral finance acknowledges that investors are human and often act irrationally due to cognitive biases and emotional responses. These behaviors can significantly impact investment decisions, portfolio performance and so, an investor’s success in achieving their ultimate goal (be it spending, gifting to charity, or to the next generation).

A study by Dalbar Inc. (the annual Quantitative Analysis of Investor Behavior report) found that the average equity investor earned a return of just 5.3% annually over a 20-year period, compared to the S&P 500’s average annual return of 9.9% over the same period.[1] This significant gap is largely attributed to poor investment decisions and making changes at the wrong time, driven by emotional decision making in financial markets. This, of course, highlights the importance of both developing disciplined, long-term investment strategies and having the tools/ people to help you stick with them.

I’ve highlighted a few of the common biases that I’ve come across:

Common Behavioral Biases

1. Loss Aversion: Investors tend to feel the pain of losses more intensely than the pleasure of gains. In fact, Nobel laureate Daniel Kahneman’s research shows that losses are psychologically twice as powerful as gains. This can lead to an overly conservative approach during downturns, where the fear of losing more can prompt hasty exits at the worst possible time.
2. Herd Mentality: The tendency to follow the crowd can be particularly harmful in investing. When markets rise rapidly, the fear of missing out (FOMO) can lead to buying at higher, often unsustainable prices. Conversely, during a market decline, the rush to sell can exacerbate losses. Remember the GameStop saga that took the struggling video game retailer’s stock price from $17 at the beginning of January 2021 to an all-time high of $483 in just a few weeks? This massive trading frenzy was fueled by social media platforms (like Reddit) where retail investors were buying the stock en masse. While some investors realized substantial gains by selling at the peak, others who bought in at a higher price experienced significant losses when the price fell back to more realistic levels.
3. Overconfidence: Many investors overestimate their knowledge and ability to predict market movements. This can result in excessive trading and risk-taking, which often diminishes returns over the long term. Research indicates that overconfident investors trade more frequently and incur higher transaction costs (and taxes), which can erode their investment gains.
4. Anchoring: This bias involves fixating on a specific price point, such as the purchase price of an investment, and making decisions based on that anchor rather than current market conditions and future prospects. A study by Tversky and Kahneman revealed that people often rely too heavily on the first piece of information (the "anchor") they receive, even if it’s irrelevant.

The Northwood Approach: Staying the Course

At Northwood, we recognize these behavioral tendencies and work diligently to guide our clients towards rational, disciplined investment strategies. Here are a few examples of how we help our clients stay the course:

1. Personalized Financial Plans: Each client’s financial plan is tailored to their unique circumstances, goals, and risk tolerance. This personalized approach ensures that the investment strategy aligns with their long-term goals and objectives, providing a solid foundation to weather short-term market fluctuations. We also ensure that the portfolio’s allocation aligns with the client’s Investment Policy Statement (“IPS”).  The IPS serves as a guiding framework, helping to keep clients tethered to their original plan and allocation, especially when the temptation to chase hot investment categories arises. Adhering to a client’s IPS, which is updated as circumstance change, helps maintain discipline and focus on their long-term financial goals. 
2. Focus on Long-Term Goals: We emphasize the importance of staying focused on long-term goals rather than short-term market movements. This perspective helps clients remain committed to their investment strategy, even during periods of market turbulence. Recognizing that goals change and evolve with time, we center our discussions on helping clients evaluate changes and understand how new decisions and objectives affect their overall investment portfolios.
3. Quantifying Goals: We've found it most effective to categorize financial goals into two main groups: "lifetime goals" and "legacy goals". Lifetime goals are things you want to achieve in your lifetime, such as maintaining a specific standard of living, purchasing a cottage, or providing support to children. Legacy goals, on the other hand, are those that won't be realized until after death (such as financial legacies to children or charitable bequests) and are typically considered secondary to lifetime goals. By dividing assets into these categories, we can better align each asset with the respective goal. This approach provides clients with comfort to “stay the course”. When there is a conservative plan to ensure that lifetime goals are fully funded, clients are less likely to react to fluctuations in the legacy bucket, which has a longer time horizon for growth and recovery from any declines.
4. Diversification and Risk Management: A well-diversified portfolio is crucial for mitigating risk. By spreading investments across various asset classes and geographic regions, we reduce the impact of any single event on the overall portfolio. Diversification is a time-tested strategy that spreads investment risk across various assets to potentially reduce overall portfolio volatility. The smoother returns over time, helps manage the emotional aspect of investing. 
5. Behavioral Coaching: Our client teams act as behavioral coaches, helping clients recognize and manage their emotional responses to market volatility by providing discipline and guidance. By providing a steady hand and a rational perspective, we assist clients in making informed decisions rather than impulsive reactions. A research study conducted by Vanguard shows that behavioral coaching can add 1-2% in net returns by preventing costly mistakes.[2]
6. Education and Communication: We also prioritize transparent communication and ongoing education to ensure our clients understand market dynamics and the long-term nature of our investment strategies. Regular updates and thoughtful analysis help explain market movements and reduce anxiety. For example, during the 2022-2023 market rollercoaster, our disciplined approach and regular communication helped clients avoid panic selling at 2022s lows (because of loss aversion).

Conclusion

In the world of investing, emotions can be a powerful adversary. Our commitment to a conservative, long-term investment approach is designed to help clients navigate the emotional ups and downs of capital markets. By understanding and addressing the behavioral aspects of investing, clients are more easily able to stay the course, ensuring that their wealth is preserved and grown for themselves and for future generations.

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[1] Note – While these results highlight the effects of emotional investing, it's important to note that some critics argue the study's methodology might not fully capture the true performance of individual investors and that comparisons to the S&P 500 may not be entirely fair. Nonetheless, the study underscores a critical point echoed by numerous sources: investor behavior, driven by fear and human irrationality, can substantially impact investment outcomes.

[2] https://www.vanguard.ca/content/dam/intl/americas/canada/en/documents/gas/quantifying-your-value-research.pdf

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