Why Understanding Human Behaviour Matters More Than You Think

When I first started investing, I believed the usual story. Read the financial statements, find good companies, buy at a reasonable price, and let time do the rest. On paper, it sounded simple. But reality has a funny way of humbling you.

Over time, I realised that the biggest challenge in portfolio management isn’t finding information. It’s dealing with ourselves. Fear, greed, impatience, overconfidence ,  these emotions quietly shape our decisions every day, often without us noticing. That’s where behavioural finance comes in. Not as some academic theory, but as a practical lens to understand why we do what we do in the market, and how that behaviour affects long-term results.

If you ignore this part of investing, even the best strategy can fall apart at the worst possible time.

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Behavioural Finance: The Missing Piece in Portfolio Management

Behavioural finance sounds like a complicated term, but the idea is simple. It studies how real people behave with money, not how textbooks assume we behave. In the real world, investors panic at the bottom, chase stories (hot stocks) at the top, and constantly compare their portfolios with others. Comparing with peers make you stressed that needs to do something (to catch up with others) and taking more risk without realizing.

In portfolio management, this matters more than most people admit. You can design a well-diversified portfolio with solid companies, but if you sell everything during a market crash because you “can’t sleep at night”, the portfolio has failed , not because of the assets, but because of your behaviour.

Understanding behavioural finance helps you anticipate your own reactions before they happen. It forces you to ask uncomfortable questions. How do I usually react when markets fall sharply? Do I become too confident after a few good years? Do I feel the urge to “do something” even when doing nothing is the right move? Do I feel stressed when stocks I bought didn't move for the three months?

Good portfolio management is not just about asset allocation. It’s also about emotional management, understand that your actions today will have impact on your overall future performance.

The Quiet Influence of Market Sentiment

Markets move on numbers ( e.g earnings, economic data), but they also move on mood. Market sentiment is simply the collective emotion of investors at a given time. Optimism pushes prices higher than fundamentals justify. Pessimism drags prices lower than logic would suggest.

You can see this clearly if you’ve been investing long enough. During bull markets, risk feels invisible. Investors stretch valuations, ignore warning signs, and convince themselves that “this time is different”. During bear markets, the opposite happens. Even strong businesses are treated as if they are permanently broken.

When constructing a portfolio, ignoring market sentiment can be costly. But reacting blindly to it is even worse.

The key is awareness. When everyone around you feels euphoric, that’s usually a signal to slow down, not speed up. When despair is everywhere, that’s often when long-term opportunities quietly appear. This doesn’t mean trying to time the market perfectly. It means understanding that sentiment swings are part of the cycle, and building a portfolio that can survive those swings.

A portfolio designed only for good times is fragile. One designed with sentiment in mind tends to be more resilient.

Psychology and Portfolio Construction

Portfolio construction is often presented as a technical exercise. Percentages, correlations, risk metrics. All of that matters, but psychology sits underneath it all.

For example, diversification isn’t just about reducing volatility. It’s also about helping you stay invested. When one part of your portfolio is falling while another is holding up, it gives you emotional breathing space. That space makes it easier to avoid panic decisions.

Position sizing is another psychological tool. Holding a position that’s too large may look fine when prices rise, but it becomes unbearable during drawdowns. Many investors discover their true risk tolerance only after markets fall. By then, it’s often too late.

A well-constructed portfolio respects human limits,our weakness or biased. It assumes you are not perfectly rational, and it designs guardrails accordingly. This doesn’t mean avoiding risk altogether. It means taking risk in a way that you can live with through different market conditions.

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The Long-Term Power of Compounding

Compounding is often described with neat charts and smooth curves, but real-life compounding is messy. There are years of strong gains, years of flat performance, and years of painful losses. The power of compounding only reveals itself to those who stay invested long enough.

What’s often overlooked is that compounding works on behaviour too. Small, sensible decisions repeated over time build surprisingly large outcomes. So do small mistakes.

Selling during downturns breaks the compounding process. Constantly switching strategies resets the clock again and again. On the other hand, staying invested in quality assets, reinvesting dividends, and resisting the urge to tinker too much allows time to do the heavy lifting.

Compounding doesn’t need brilliance. It needs patience and consistency. Unfortunately, patience is in short supply during volatile markets.

Regression to the Mean: A Reality Check

Regression to the mean is one of the most uncomfortable ideas in investing, especially after periods of strong performance. It simply means that extreme outcomes tend to move back toward average over time.

Exceptional returns often attract attention, money, and confidence. But high returns are rarely permanent. Likewise, periods of poor performance often feel endless, but they usually don’t last forever either.

Understanding this concept helps keep expectations grounded. When a stock, sector, or strategy performs extraordinarily well, it’s wise to be cautious. When something has been punished for years, it may deserve a closer look rather than outright dismissal.

Regression to the mean doesn’t mean everything reverts neatly or quickly. We can't expect the stocks we bought recently to revert to mean day after we bought it, sometimes it may take years for business to recover, hence, patience is important ingredients. It means extremes don’t persist indefinitely. For long-term investors, this insight helps avoid chasing what’s hot and abandoning what’s temporarily out of favour.

Behaviour, Time, and the Investor’s Edge

In the end, the real edge in investing rarely comes from superior information. Markets are too competitive for that. The edge comes from behaviour , from doing sensible things consistently while others struggle with emotion.

Time amplifies this edge. Over decades, small advantages compound, while repeated emotional mistakes add up. Investors who understand their own psychology, respect market sentiment, and stay patient through cycles often outperform not because they are smarter, but because they are steadier.

This is especially relevant for long-term portfolios. The goal isn’t to win every year. It’s to reach your financial objectives without being derailed along the way.

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Final Thoughts

Portfolio management is often framed as a numbers game, but at its core, it’s a human one. Behavioural finance reminds us that markets are made up of people, each carrying their own fears, hopes, and biases. Ignoring this reality makes investing harder than it needs to be.

By understanding market sentiment, respecting psychology in portfolio construction, and appreciating the long-term forces of compounding and regression to the mean, investors give themselves a better chance of staying the course.

There’s no perfect portfolio, and there never will be. But there is a thoughtful one that built with an awareness of how markets behave, and more importantly, how we behave within them. Over the long run, that awareness can make all the difference and it will eventually reflect on your returns / performance.

Till next update 😊 

Cheers!

STE