In the quest for investment returns, classical finance theory makes little room for sentimentality. But the failure of economic theory – and the financial services industry – to fully appreciate the consequences of being human (and all the emotions that make us who we are) is one of the primary sources of poor investment advice.

Estimates suggest that investors lose 2-5% of potential returns each year simply because being human makes the principles of classical finance hard to follow. By ignoring the important role of emotions, traditional portfolio solutions end up making investors uncomfortable along the journey and that frequently leads to poor decision making and lower performance. For example: we pay too much attention to the short term; we over-react to market movements; we buy when markets are doing well, and sell when markets are low; and we retain large portions of our wealth in cash, unused and unproductive.

Despite what theorists may say, none of these actions are necessarily ‘irrational’. We get something important in return – we get to sleep at night! The truth is we all need emotional comfort. If you’re anxious that markets will fall, selling out provides the relief of knowing you won’t lose any more money. But once you’ve left a turbulent market for emotional reasons, it’s almost impossible to quickly get back in again, no matter how good the logical case for it. You lock in the losses and miss the eventual rally. This is short-term emotional comfort purchased at enormous financial cost.

How much should you pay for emotional comfort? Traditional finance says ‘zero’: emotion is to be controlled, not pandered to. But when we aim for perfection – and bet against the forces of human fallibility – we often fail (expensively).

Instead, we should accept our need for comfort, and then seek cost-effective ways of acquiring it, maximising anxiety-adjusted returns rather than merely risk-adjusted returns. Behavioural finance can help identify the aspects of investing that make an individual investor most nervous, and find targeted ways of reducing anxiety as cheaply as possible.

This may mean keeping a reasonable portion of wealth in cash for security. It may mean purchasing ‘downside protection’ in the event of extreme market moves. Or it may mean sacrificing some long-term upside to focus the portfolio on investments that feel more comfortable. All of these cost something, but provide the emotional insurance to help you to invest your wealth productively for the long term, and get to sleep at night.

No matter what stance you take to investing, your capital is still at risk.

Greg B. Davies, Head of Behavioural and Quantitative Finance