Significantly over 80 percent of people on the road claim to be above-average drivers. This figure is similarly high for capital market participants when asked if their actions are rationally or emotionally driven.

By Thomas Wille, Senior Investment Strategist at LGT

It goes without saying that a large majority of market participants is convinced that they make decisions on a purely rational basis, primarily based on facts. But how do they react to developments in financial markets? Was their reaction to Brexit or the outcome of the US election rational or emotional?

There is no clear-cut answer to these questions. Generally speaking, rational or emotional behavior is dictated by whether gains or losses are involved. The explanation for this lies in perception.

The Emergence Of Investment-related Tunnel Vision

A loss of one franc results in around the same level of emotion as a gain of 2.40 francs. Because of this inconsistency, investors often vacillate between the two worlds. They are caught in their own subjective or selective perception, they are rigid and emotionally attached to their analysis. People who at the outset were rational decision makers, all of a sudden find themselves somewhere between faith and hope.

As a rule, neither of these states provides good counsel or support when making decisions. At these times, self-reflection often fails to materialize. Instead, attempts are frequently made to substantiate a preconceived, self-defined capital market view using a multitude of information. Reality is projected into a pre-defined vision and the actual facts are selectively blocked out. The higher the loss, the more predominant this behavior becomes.

Google Or Post-Truth Investing

Thanks to the internet and Google, the 21st century provides access to an almost endless amount of information. This allows «rational» investors to create their very own world of ideas. At first glance, this world looks logical and well thought out. It can, however, be fraught with emotions, despite all the facts.

Fear, greed, overconfidence and to some extent, unrealistic expectations or a non-linear perception of financial gains and losses are just a few examples thereof. The wide variety of irrational behavior is beyond the scope of this article. But the fact is: these generally all lead to emotionally-driven investment decisions by rational investors.

The line between rational behavior and an emotional dilemma is very narrow and depends primarily on market developments. Favorable capital markets make it possible for almost every market participant to ride the upward trend. Decisions that have been reached emotionally have no negative consequences in this kind of a situation. However, the tables can turn quickly if investments start to teeter. That is when emotional behavior sets in and takes over.

Rational Escapes From The Emotional Trap

How can investors protect themselves? On the one hand, they should build on a robust investment strategy that positions their investments for good times as well as bad. On the other hand – and this is of key importance in my view – investors should always have a plan or a predefined path in mind. By considering various scenarios, investors should define beforehand how best to react in the event of a positive, neutral or negative result.

In reality, it will never be possible to react in a way that is free of emotion. But particularly in times of high volatility, it is crucial to have a predefined plan in place in order to secure assets when stress levels run high. Such a plan could, for example, include a predefined stop-loss or a risk indicator at the portfolio level, with the objective of limiting losses on assets and securing capital.

Despite our high-tech world and its increasingly complex financial instruments, emotions remain an important factor in capital markets and should not be underestimated by “rational” investors.

Thomas Wille is a Senior Investment Strategist at LGT, responsible for the investment strategy for our private clients in Europe. He studied finance at the University of St. Gallen and has worked in financial markets for over 20 years in the areas of investment strategy and asset allocation. In addition to fundamental analysis, he also places particular focus on how behavioral finance-related factors influence capital markets. As a lecturer for applied economics, he shares his knowledge with engineering students studying at the Lucerne University of Applied Sciences and Arts.