KEY POINTS:
We are enduring the greatest turmoil in investment markets for two decades. As always, the short-term path of markets remains uncertain and confusing. But none of this is likely to undermine the path and attractive returns of a sensibly constructed investment portfolio.
The reality for most investors is that the enemy lurks within us, rather than in the external forces that influence markets. Whether investing in shares, property or plain old cash deposits, we often make irrational decisions. Yet there are simple, effective strategies to overcome these hardwired instincts.
Dollar cost averaging, which involves investing predetermined amounts in the markets at predetermined dates, takes the emotion out of investment decisions. Regular savings plans do the same.
But why are strategies which strip out the emotional "human" element of investing, so effective? It boils down to prehistoric times, when the fight-or-flight response evolved. Evolution has geared us for short-term survival and our orientation is to make snap judgments in response to new, alarming information.
Today, the environment in which we make decisions has changed much faster than the human brain has evolved. As a result, we are predisposed to make mistakes because our brains cannot keep up with the world around us. Kneejerk reactions and emotional "thought traps", if not kept under close control, can easily derail our investment strategy.
Trap 1: Judging a book by its cover.
Making judgments based on stereotypes is one of the most common mental mistakes. Every time we meet a new acquaintance, we usually know within seconds, certainly minutes, whether we are going to like this person.Occasionally we really "click" with someone, experiencing instant rapport.
This ability to interpret a situation instantly is a survival mechanism that evolved to help humans avoid threatening people and situations. But it doesn't always work as nature intended.
For example, one of the most threatening situations imaginable is to come face to face with a sociopath, at worst a serial killer. Such people are often capable of masking their underlying nature by adopting characteristics representative of a more appealing personality type. We could easily be fooled.
Much the same process - without such potentially dire consequences - can occur when making investment decisions. Relying on stereotypes to make financial decisions, rather than assessing facts, means that we may overreact to new information.
Finance company investors have learnt this lesson the hard way.
Trap 2: Past performance does not equal the future.
The unconscious tendency to believe that past performance is a predictor of future performance is widespread and destructive.
But no matter how often those words are repeated, past returns continue to exert a powerful hold over many investors. Something about human nature makes us want to believe that if something has done well, it's likely to go on doing well.
It would be foolhardy to completely ignore performance when assessing investments. Just remember that performance history is only one of a number of factors to consider.
A long track record of consistent performance is usually a good sign. But beware: the management team responsible for that performance might have left the company just last month.
No performance number tells us that, yet it happens more frequently than most might imagine.
The recent past provides a perfect example: investors who poured money into high-tech shares did spectacularly well before the dotcom crash of 2000, but anyone who persisted with that strategy will have been sorely disappointed.
Studies have shown that in many cases, investors with a short to medium time horizon would be better off selecting funds from among the worst recent performers than from among the best.
Trap 3: I saw it with my own eyes.
Another destructive tendency for investors is to over-emphasise major events, particularly those that occurred recently.
It can cause investors to overreact and abandon sensible strategies at just the wrong time. Investors who modify their reactions to extreme events in a more reflective fashion usually emerge in good shape from these shocks. They understand that investment markets tend to produce good returns over the long term.
This helps explain what occurred in sharemarkets in the days that followed September 11, 2001. Shares plunged worldwide, with investors in the United States pulling approximately US$29.5 billion out of their share funds in panic.
Five days later, however, the US S&P500 index enjoyed its second largest one-day gain of the year. Within a month it had risen 3.7 per cent, rewarding investors who held firm during these psychologically testing times.
Trap 4: I found it, so it must be important.
Investors often over-emphasise the value of information that is easily accessible, rather than searching out and relying on alternative sources. This means many prefer shares that grab their attention.
However, high-attention shares are more likely to be those that are in fashion, their prices having already risen so that a fair amount of future profit has already been factored into their market prices.
This means investors often experience the opposite result to the one intended, because they are buying high and may later be forced to sell low.
Stick to your plan and ignore short-term noise. Each of these thought traps poses a significant short-term threat to investment decision making. Each makes it more difficult to work out what is important or not in achieving longer-term goals. It's about setting goals, staying focused and learning to master your mind.
There is only one more action you can take beyond old-fashioned homework of the Warren Buffett variety and controlling your emotions: engage an adviser who can help you make smart decisions.
Arun Abey is executive chairman of financial planning firm Ipac, head of strategy for AXA in the Asia Pacific and a director and advisory board member of Spicers Portfolio Management. He is also the author of How Much is Enough?
www.howmuchisenough.net
