An extraordinary performance by the Australian share market over the fast closing financial year has the potential to induce a psychological hangover for investors.

In the second half of the financial year, investors saw both the all-time high for the Australia 200 index, and a seven-year low. The wild swing in sentiment created by the Covid-19 black swan event meant many investors experienced elation and despair in a very short period of time. Those who then bought near the March 2020 lows rode the market rollercoaster, and are potentially finishing the financial year on a high.

Investors looking for success in the year to come are likely reading financial forecasts, analysing central bank activity, and thinking about the conflicting effects of lockdown measures and government support. But perhaps the most important exercise to aid investment in the financial year to come is to look at the impact of any extreme emotional experiences resulting from the 2019/20 wild market ride.

Most professional traders realise that the principles of profitable trading are straightforward. Any trader who can cut losses, and run profits, will make money. Traders whose selections are wrong more often than right can still win if their losses are small, and they stick with good trades to maximise profits.

If trading markets is so easy, why doesn’t everyone make money? The reason is that while the principles of success are very easy to state, implementing them consistently is much harder. This is why so much energy is spent analysing the psychology of markets.

Behavioural economics is one of the fastest expanding areas of financial market study, largely replacing classical economic market theory. Hedge funds employ cognitive psychologists to coach and advise their traders. Algorithmic traders mechanise their trading process to limit human interference once the trading starts. These developments speak to the usefulness of understanding real human behaviour under financial pressure, and the ability of emotions to hijack an investment approach.

So understanding the emotional impact of the unusual market conditions of 2019/20 is pivotal to better 2020/21 investing. Investors had different experiences, depending on their approach and exposures to the huge market moves.

In Malcolm Gladwell’s “David and Goliath”, he wrote of the varying responses of Londoners to the Blitz air attacks on the English capital during World War 2. Of course, a bad day in the markets is better than a good day in a warzone, but the parallels are illuminating.

A number of studies found that the proximity to a bomb strikes was a key determinant of psychological responses. Those who suffered direct hits had no further earthly concerns. Those who endured a near miss were often badly affected, and were subject to heightened fear, and anxiety approaching paranoia, as might be expected. However many who lived through remote misses exhibited counterintuitive behaviour.

Londoners who were a mile or more away from dropped bombs heard the air raid sirens, saw the planes, and felt the explosions. Yet in the main, they did not become more fearful, but instead became more confident. Psychologists postulate that surviving such a terrifying event unscathed led many of them to believe they were invulnerable.

Some investors who bought into the market before the February peak, and then sold out near the March low, may have vowed to never buy shares again. Investors in this group have no more stock market concerns. I recently spoke privately to a well-known financial personality who confessed to exactly this response to the GFC. Despite their status as a widely respected commentator on stocks, they have not owned a share since 2010.

Investors who suffered significant losses in the Covid-19 disruption, and did not recoup much of their losses in the subsequent rally, could be feeling heightened risk aversion. They may have shifted much of their portfolio out of the share market, or rotated into shares they believe are lower risk. Investors in this group may be more concerned about the economic outlook.

Lastly, investors who profited from the market mayhem – whether by hedging their portfolios, or buying into shares near their lows, could be exuberant. To profit when others are losing can bolster self-confidence, potentially into over-confidence. New investors who bought shares after the March low are the extreme example. They have never experienced a trading loss, and are possibly thinking that making money in the markets is easy.

Investors must examine their own experience to determine if their mindset requires adjustment. Emotions are an essential part of the human experience, and the enemy of balanced analysis and investment.

This article first appeared in the Australian Financial Review

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