Managing behavioral biases, market volatility and investment journey uncertainty

Soros explained these ideas succinctly: “I can state the central idea in two relatively simple propositions. The first is that in situations where participants are thinking, the participants’ worldview is always partial and distorted. This is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. »

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He further noted that financial markets often exhibit self-reinforcing boom-and-bust cycles that ultimately prove self-defeating, a phenomenon also observable in other areas.

Soros’ philosophy – a blend of financial returns, personal experience and economic theory – proved invaluable during the 2008 financial crisis. His ideas remain relevant today, especially as we find ourselves in a global electoral supercycle amid rapid and unpredictable market movements.

Political and economic changes, from the Indian election results to Donald Trump’s assassination attempt and Joe Biden’s withdrawal from the US elections, are compounded by currency fluctuations and the rally of US small and mid-caps against the Magnificent 7. This unpredictability begs the question: can we predict market movements?

The short answer is no: we cannot predict the market with certainty. Market movements fall into the category of unknown unknowns. Financial markets are influenced by a myriad of interrelated variables, making it nearly impossible to isolate the effect of any single factor. The complex interplay of market forces, human behavior and external shocks makes forecasts uncertain and inherently unpredictable.

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However, even though we cannot predict the future accurately, we can still prepare for it. Two approaches are essential: qualitative and quantitative. Each method offers unique insights, and together they help investors manage financial market uncertainties.

Plan when uncertain

Quantitative approach:

In times of volatility, protecting capital becomes more crucial than maximizing returns. This may involve maintaining a larger cash reserve, purchasing insurance, or covering yourself against unforeseen events. Avoiding FOMO (fear of missing out) is essential but difficult. An investment plan should align with an individual’s risk tolerance, whether conservative, moderate, balanced or aggressive, with corresponding asset allocations.

Qualitative/behavioral approach:

Understanding human biases is essential when evaluating investment decisions. Biases can be classified into two categories:

Cognitive errors: These include conservatism, confirmation bias, representativeness, illusion of control, hindsight bias, anchoring, and mental accounting.

Emotional biases: Examples include loss aversion, overconfidence, self-control, status quo bias, endowment effect, and regret aversion.

These biases are deeply ingrained in human psychology and often operate unconsciously. Cognitive errors, such as reliance on heuristics, can be difficult to recognize, while emotional biases can override rational thinking. Psychological resistance, such as cognitive dissonance and confirmation bias, further complicates decision-making by encouraging us to reject information that contradicts our beliefs.

These biases are deeply ingrained in human psychology and often operate unconsciously. Cognitive errors, such as reliance on heuristics, can be difficult to recognize, while emotional biases can override rational thinking. Psychological resistance, such as cognitive dissonance and confirmation bias, further complicates decision-making by encouraging us to reject information that contradicts our beliefs.

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Just as it is almost impossible to time the market perfectly, it is equally difficult to control these biases. The best defense is a foolproof portfolio, diversified between traditional assets (equities, fixed income), inflation hedge assets (commodities) and ambitious investments (venture capital, private equity, hedge funds, debt risk and efficient credit).

As financial markets experience increasingly frequent and volatile boom-bust cycles, investors must remain flexible and open to new information, echoing John Maynard Keynes’ famous sentiment: “When the facts change, I changes your mind – what are you doing, sir?

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This mindset is crucial not only in finance but also in life. Events beyond our control will challenge our predictions and behaviors. Our emotions and prejudices inevitably influence our decisions, sometimes to the detriment of recognizing the facts. By embracing uncertainty, remaining disciplined, and maintaining flexibility, we can better navigate an unpredictable world.

Prashant Tandon, Senior Director, Listed Investments, Waterfield Advisors.