In the intricate and often unpredictable world of investment, the intersection of psychology and finance, known as behavioural finance, explains why investors frequently make irrational decisions.

Traditional financial theories assume that investors are rational, always acting in their best economic interest based on available information. However, behavioural finance reveals that cognitive biases, emotions and social influences can significantly skew investment decisions. In this context, the role of professional investment advice becomes crucial in helping investors navigate these biases and make more rational, informed decisions.

Understanding behavioural finance

Behavioural finance delves into the psychological factors influencing investors, shedding light on why markets are not always efficient and why asset prices can deviate from their intrinsic values. Key biases that affect investment decisions include:

Overconfidence bias: Investors often overestimate their knowledge and ability to predict market movements, leading to excessive trading and poor diversification.

Loss aversion: The pain of losing is more impactful than the pleasure of gaining, causing investors to hold onto losing investments too long or sell winners too early.

Herd behaviour: The tendency to follow the crowd, especially in times of uncertainty, can lead to asset bubbles or market crashes.

Role of investment advisors

Professional investment advisors play a critical role in mitigating the impact of these biases on investment decisions. Their expertise and objectivity can guide investors towards more rational behaviour, ultimately enhancing investment outcomes.

Providing education and awareness

Advisors educate investors about common behavioural biases and their potential impact. Awareness is the first step in recognising and countering irrational behaviour. By understanding these biases, investors can make more informed decisions, rather than being swayed by emotions or cognitive distortions.

Ensuring diversification

Advisors help investors construct diversified portfolios that spread risk across various asset classes, sectors and geographies. Diversification is a fundamental strategy to counteract overconfidence and loss aversion. A well-diversified portfolio reduces the impact of poor performance in any single investment, promoting more stable returns over the long term.

Adopting a long-term perspective

Professional advisors encourage investors to maintain a long-term perspective, reducing the tendency to react impulsively to short-term market fluctuations. By focusing on long-term goals and fundamental value, investors are less likely to be influenced by short-term noise and emotional reactions.

Implementing predefined rules and strategies

It is advisable for investors to establish and adhere to predefined investment rules and strategies. These rules can include systematic rebalancing, setting stop-loss orders, and following a disciplined investment approach. Such strategies help remove emotions from the decision-making process and ensure that decisions are based on sound financial principles.

Offering objective guidance

One of the most valuable roles of an investment advisor is to provide objective guidance. Advisors act as a sounding board, offering a rational perspective when investors are tempted to make impulsive decisions. This objectivity is crucial during periods of market volatility, where emotional responses can lead to significant financial mistakes.

Case study: The value of advisor intervention

Consider an investor who, influenced by herd behaviour and overconfidence, is heavily invested in a trending technology stock. The stock begins to show signs of volatility, but the investor, anchored to the high initial price, is reluctant to sell.

A professional advisor can provide a comprehensive analysis of the stock’s fundamentals and the broader market context, highlighting the risks of overexposure to a single asset. By recommending diversification and potentially reallocating funds to more stable investments, the advisor helps mitigate the risk and align the portfolio with the investor’s long-term goals.

Behavioural finance reveals that cognitive biases and emotions significantly influence investment decisions, often leading to irrational behaviour that can undermine financial goals. By leveraging the expertise of professional advisors, investors can navigate the complexities of the financial markets more effectively, making rational decisions that enhance their investment outcomes.

As the investment landscape continues to evolve, the collaboration between behavioural finance insights and professional advisory services will remain pivotal in achieving financial success.

Beppe Jaccarini is a capital markets analyst at Curmi & Partners Ltd.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.