The Hidden Human Factor in Investment Performance

But even the best investment process can go wrong. The reason is simple. People ultimately make the investment decisions. There is human judgement in almost every part of investing – judging which information is worth paying attention to, estimating probabilities, interpreting market movements, deciding on position sizes, knowing when to buy or sell. Investors may come to very different conclusions when they have access to the same information, because the decision-making process is influenced by psychology, emotion and the environment in which the decision is taken.

That doesn’t mean investors are irrational all the time. In fact, behavioral finance suggests something more interesting: people can make decisions that feel perfectly rational at the time, but which lead to systematically poor outcomes over time. The challenge then is not to discard human judgement. It's about designing investment processes that make human judgement more reliable.

When a Great Strategy Meets a Human Decision Maker

Imagine a buying team has identified a company with strong fundamentals. Revenues are growing, margins are improving, and management has a credible long-term strategy. The team will determine a valuation range and decide what price they find attractive for the stock. The process looks disciplined on paper. Then the stock drops 20%.

The investment thesis may still be intact, but the declining price is uncomfortable. Investors start looking for reasons to explain the fall. News coverage is becoming more influential. One colleague says the market may know something the team doesn’t know. Eventually the position is sold, not because the original analysis was disproven, but because the psychological experience of being wrong became intolerable.

Now think the other way around. You buy a stock, and it goes way up. The investment team gains more confidence in its original analysis. Additional evidence in support of the thesis is paid more attention to, and contradictory evidence is given less weight. The role could be bigger than initially thought. In both cases, the problem may not have been the investment strategy itself. The problem happened between analysis and action. This gap between what an investor intends to do and what an investor actually does is one of the most important problems in behavioral finance.

The Evidence for Behavioral Decision-Making

The idea that investor behavior can affect returns is not just theory. Brad Barber and Terrance Odean conducted one of the most influential studies of individual investors, examining the trading records of 66,465 households from 1991 to 1996. Over the period, the market earned an annual return of 17.9 percent compared with 11.4 percent for households that traded most frequently. The average household earned 16.4% with an annual turnover of about 75% of the portfolio.

The researchers said in their paper that excessive trading, partly associated with investor overconfidence, can exact a substantial performance penalty. The lesson is important. More conviction does not necessarily lead to better investment results. At other times, confidence leads investors to trade too much, when trading less would have been better.

A similar pattern appears when researchers look at individual investment decisions, rather than just overall trading activity. Terrance Odean examined the trading records of about 10,000 brokerage accounts and discovered that investors were more likely to have gains than losses. Notably, the stocks investors sold at gains subsequently outperformed the losing stocks they kept holding. This illustrates how a seemingly minor decision, whether to sell one investment over another, can affect portfolio performance.

The Portfolio Return Is Not Necessarily the Investor's Return

One of the most obvious ways that the human factor shows up is the difference between the reported return on an investment and the return that investors actually experience.

Morningstar’s Mind the Gap research tracks the difference between fund total returns and the returns investors earn on the average dollar invested in the fund. For the 10 years ending December 31, 2025, the average dollar invested in U.S. mutual funds and ETFs earned roughly 8.7% a year, compared with 9.9% for the funds themselves – a shortfall of about 1.2 percentage points a year. The difference was primarily in the timing and the number of investors' buying and selling.

And that distinction matters. A fund can do well, but its investors get less of that performance because they get in after strong gains, pull back in uncertainty, or sell after declines. That is why the performance of the underlying asset is not always a good reflection of the investment performance. The way decisions are made about investment matters too.

Case Study: GameStop and the Collective Behavior

The GameStop episode in January 2021 is a modern example of how human behavior can interface with technology and social networks. Retail investors, most notably in online communities such as Reddit’s WallStreetBets, rallied around the stock, and the share price skyrocketed. Research into the episode found a correlation between Reddit activity and retail trading, and other research found strong correlations between GameStop and other heavily shorted stocks during the episode.

The importance of GameStop is not whether the stock was fundamentally under- or over-valued. It showed how fast information, opinions, and emotions can move through a connected investment community. A stock that a trader may have missed on his own can become interesting when he sees thousands of other participants talking about it.

This means that traditional investment processes are facing a tough environment.

The choice is no longer simply:

"Is this company good value for money?"

It can turn into:

“What else is everyone buying?”

That change can turn investment analysis into social decision-making. GameStop is therefore a case study of a growing challenge for modern investors: behavioral influences are no longer confined to traditional market environments. Social media, real-time notifications, and online investment communities can accelerate this.

Information Doesn't Equal Better Decisions

Investors today have more information at their fingertips than ever before. Immediate availability of financial statements. You can track market data in real time. Analyst reports, economic forecasts, company presentations, alternative data, and social-media sentiment are available to investors from a smartphone.

But more information doesn’t always lead to better decisions. Behavioral decision-making research has shown time and time again that the way information is presented can influence choices. Kahneman and Tversky’s work on decision framing demonstrated that people can make different choices when the same outcomes are presented in different ways.

In financial markets, this creates what can be broadly described as a signal-vs-noise problem. Not all price movements carry useful information. Not all analysts’ forecasts are made equal. Not every market narrative is a change in fundamentals. An investor who reacts to each new fact may be increasing the chances of making bad decisions.

A solid investment process should therefore answer not only:

“What do we know?”

but also:

“What information should guide our decision?

Why Rules Work Better Than Willpower

One of the best ways to reduce behavioral mistakes is to shift important decisions from the moment of emotional pressure to an earlier, calmer time. For example, an investor can set an exit criterion before buying an investment. Instead of deciding to sell the investment after it has dropped 25%, the investor can decide upfront what would invalidate the original thesis. Position sizing works on the same principle.

When conviction is strong, the investment process can define how that conviction is reflected in the portfolio’s exposure. If a position becomes massively larger because of a price increase, predefined rules for rebalancing can help prevent the portfolio from becoming unintentionally concentrated. Cooling off periods can help too. After a large movement in the market, investors can require more analysis before making a big portfolio change. These rules do not remove emotion. They stop emotion from being the only decision-maker.

Why It Is Important to Measure Behavior

In the investment process, you can’t improve what you don’t measure.

Portfolio teams can track the following indicators:

• How often positions are created or decreased

• Whether decisions are made following unusually large price changes

• How often investment theses are changed

• If winning positions are held longer than losing positions

• How frequently portfolio choices conflict with the stated strategy

• If position sizes are consistent with stated conviction

• How often investors change their minds after making a decision

That is a big change. Instead of simply asking, “Did the investment make money?” investors can ask: “Was the decision made in the way we intended to process it?”

A decision can be profitable but poorly made if it was based on luck. Markets are uncertain, so conversely, a well-reasoned decision can lose money. Performance is partly luck, partly skill. Investors can’t control what the markets do, but they can control the quality and consistency of their decision-making process.

Developing a Superior Investment Process

A good investment process should thus have multiple layers of protection against human error.

First, begin with base rates

When making a detailed forecast, first consider what usually occurs in similar situations. This takes away the temptation to make a story out of one company or one event.

Second, use ranges, not false precision

The markets are unclear. The projection of a single target price may create the illusion of certainty; a range prompts investors to acknowledge uncertainty explicitly.

Third, get the thesis away from the price action

A declining stock price does not mean an investment thesis was wrong any more than a rising price means a thesis was correct.

Fourth, write down decisions

Writing down why you bought an investment, what would invalidate the thesis, and what information would change your view helps separate real learning from hindsight.

Finally, review the process, not the outcome

An investment review should ask what happened, what was known at the time, what assumptions were made, and whether the decision conformed to the agreed framework.

The human factor can be a competitive advantage.

As it pertains to investing, human psychology is often cited as a weakness. But it can also be a source of competitive advantage, if handled properly. Investors don't have to be perfectly rational. That is neither practical nor necessary. Instead, the goal should be to find where human judgement is most susceptible and create processes around those susceptibilities. The best investment houses know that discipline is more than just rules. It is about designing rules that still work when uncertainty, fear, excitement, and social pressure are at their highest.

Ultimately, successful investing is not only about finding the right company, predicting the right market direction, or building the most sophisticated financial model. This is about making good decisions all the time when the future is unknown. There is always a human element to investing. The question is, does the investment process design control it, or does it let it control the portfolio? So, better investing is not about removing humans from the equation. It's about creating a process that makes humans better decision-makers.

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By Sasly Ahmeth, Social Media Executive, GLC Europe, Colombo Office, Sri Lanka.