Behavioral Finance to Address Market Uncertainty: Don’t Get Distracted by the Sirens

In light of the current economic-health crisis that we have been experiencing for over a year, the
question many investors are asking is how situations of uncertainty in the markets may not
necessarily represent a negative factor, but could even offer an opportunity for their savings.
Clearly, this is not easy to navigate, and this is where behavioral finance comes into play.

Looking at the Past Is Not Enough

The simplest thing to do in these cases is to look at past performances during times of crisis.
However, two aspects must be taken into consideration:

1. Every crisis has a unique origin, development, and explosion, and they always
   manifest in different ways. Moreover, crises are sometimes the result of irrational
   behaviors by investors, making us all accomplices and victims, from the famous 1637
   “Dutch Tulip” Mania to more recent ones, such as the 2006 subprime mortgage crisis,
   the 2015 Chinese stock market crash, and even the current one.
2. We experience market events based on our personal history, our knowledge of the
   surrounding events, and the influence of the opinion leaders we have chosen as
   reliable sources for our preferences.

At this point, it becomes clear how complex it is for an individual investor to decipher which
events represent a threat and which are an opportunity for their portfolio. In moments of doubt, it
is, conversely, much easier to be swayed by irrationality.

The Remedy for Irrationality Is Behavioral Finance

Behavioral finance has become a well-known field among financial professionals, and its recent
literature has effectively highlighted how investors‘ behaviors often do not find rational
justification, and consequently, lack consistency with the investment decision-making
process. This happens because, when faced with unexpected events, we tend to make
decisions in an approximate manner, relying on so-called “heuristic biases“—mental
shortcuts our brains use to estimate unknown probabilities and make decisions in
ever-changing external contexts.

In this regard, the French economist Maurice Allais developed his famous paradox, questioning
the theory of expected utility and demonstrating how individuals behave ambiguously when
choosing between almost certain and probable events.

For instance, we might make decisions based on a limited set of information, fall prey to
representativeness heuristic, change our mind depending on how data is framed (the
so-called “framing effect“). Furthermore, an investor who, in theory, would benefit from seeking
higher expected returns in exchange for increased risk, might instead be influenced by recent
market trends and his short-term experiences due to loss aversion.

Avoid Being Tempted by the Sirens

I often discuss these aspects of behavioral finance with my clients, as I believe that emotional
factors are just as important as the technical aspects of the markets.
Moreover, I believe that financial education must be a continuous process to help raise awareness of investment
choices. This is the real opportunity to leverage during times like the one we are experiencing.
Rather than simply discussing how every crisis in the long run has been overcome through the
ability to maintain positions and “keep a steady nerve,” it is crucial for investors to internalize
the need for proper planning, based on expected utility or concrete life goals.

Everything else is navigation toward a goal, subject to unpredictable changes in external
conditions that should not make us lose our way. Using a metaphor, I would say that along
the journey, there will be false myths and temptations that seem irresistibly attractive, such as
the idea that one can get rich through trading or Forex, or that one should sell before every
political election (or referendum) and then buy back, or that the Euro is nearing its end… New
“temptations” will always arise!

In a sense:

The investor should act like Odysseus, who, in his emblematic “self-commitment,” limits himself
in the face of the sirens, knowing that resisting their call rationally is impossible.

In conclusion, whether a situation presents an opportunity or a threat during a crisis depends
on the investor’s ability to see the financial advisor not only as a professional manager
capable of identifying investment solutions aligned with the risk/time relationship—something
a robo-advisor could handle—but more importantly, as an emotional manager who
understands the needs or fears related to the fate and destination of one’s money.
Because behind every opportunity or threat lies a range of emotions that vary from client to
client.

The investor should begin to ask themselves:

• How many times has my advisor providentially contacted me to consolidate my gains?
• How many times has he been a positive obstacle in preventing me from capitalizing on
  losses?
• Without my advisor, would I have saved the same amount?
• Am I aware of my risk profile and my time horizon?

Can I help you answer these questions? Contact me.