KEY POINTS:
The investment world is more volatile than ever. But whether it's the 1997 Asian sharemarket collapse, the bursting of the "dotcom bubble" in 2000, the US sub-prime crisis or the failure of New Zealand finance companies - to name some recent examples - there are ways to overcome the mental traps that undermine investment success during uncertain times.
But what are some of these mental traps and how can they be defeated?
Much of the human brain's development occurred with the emergence of hunter-gathers on the African savannah 200,000 years ago, where day-to-day survival was the paramount need. As a consequence we tend to lack perspective when faced with the rich and complex world of the 21st century, and we particularly struggle with making good decisions when it comes to investing.
A major problem is that our decision making is influenced strongly by mental shortcuts when we face a situation of uncertainty. Anchoring - the tendency to latch on to an initial piece of data, against which we then judge all future information - is a key example. Investors may become anchored to the current prices of shares or assets, making themselves vulnerable to making misjudgments about the future.
Anchoring can also compound other mental mistakes, such as the investor's tendency to be over-confident. In a rising sharemarket, for example, investors tend to assume that current prices are roughly fair value, and each new market high becomes an anchor against which subsequent highs are judged. When values are going up investors have a propensity to be excessively confident of their abilities, which may contribute to their tendency to:
* Try to DIY, without the necessary skills and experience.
* Make decisions too rapidly, without sufficient analysis.
* Fail to diversify portfolios sufficiently.
* Trade investments too frequently.
Research shows that investors who had recently done well from investing in shares and moved their activities online, traded stocks more frequently, speculated more and achieved lower returns. In theory, trading through the internet should lower costs and lead to faster processing. But the biggest problem of investing through the internet is that it leads investors to trade too often, as it enables them to act too easily on over-confidence.
There are other common mental traps.
Hyperbolic time discounting
In essence, this is the human tendency to prefer smaller payoffs now, over larger payoffs later. Being mortal creatures with limited life spans and resources, the human survival instinct has evolved to appreciate that one cannot enjoy a conserved resource tomorrow if one doesn't survive today. This hard-wired tendency may be the bias causing many people to make decisions which lead to short-term pleasure but long-term disaster. An example is blowing a recent inheritance on a new car rather than investing it to support you in your retirement.
Myopic loss aversion
Myopic loss aversion describes how people suffer more pain from the loss of a dollar than the pleasure they get from an equivalent gain. When people invest in the sharemarket for the long term, but only measure their short-term performance, the result is a spectacular failure to stay the course and enjoy the equity risk premium - the return which shares offer, over and above the return on cash.
The equity risk premium is one of a handful of resilient forces in the world of investing. By investing in a quality diversified portfolio, having a long-term outlook and avoiding kneejerk reactions to short-term volatility, it's quite easy to achieve strong returns. Yet this prize eludes many investors because they react to short-term market movements rather than sticking with their long-term plans.
Herding
Going along with the crowd is such a strong evolutionary advantage in the savannah that it is ingrained in us, even though in the modern world it can produce highly destructive outcomes when used inappropriately. How many investors were burnt in the 1987 sharemarket crash because they invested along with everyone else?
The key to guard against these mental mistakes is to be prepared properly, so you keep your head during the fluctuations in investment markets, while those around you lose theirs.
Research companies or funds and have a good knowledge of their fundamentals. Do your research in areas that interest you and that you have some knowledge about in areas where you're likely to do a better job.
* Have the confidence and discipline to act when the opportunity arises. Don't get caught up in the herd; don't be too greedy - you won't pick the bottom or the top.
* Make investment decisions within an overall plan and seek professional advice. Again, do your research on good financial planners. This will assist with issues of over-confidence and anchoring.
Warren Buffett, one of the world's most successful investors, uses three main techniques to overcome behavioural limitations:
* Reframing the way the market works and considering volatility as a friend which provides opportunities.
Undertaking rigorous analysis on companies before making decisions. This provides confidence and mental fortitude to see the fluctuations in markets as good rather than bad.
* Having reasonable expectations of performance, remaining patient and avoiding the distractions of greed and peer pressure. This resilience is drawn from an array of disciplines including philosophy, psychology, economics and finance theory.
During volatile times, it is said "money moves from weak hands to strong hands". The winners keep their heads when others lose theirs. Mastering your mind is the key to ensuring that you will be one of the few to have strong hands.
* Arun Abey is executive chairman of financial planning firm ipac, head of strategy for AXA in the Asia Pacific and a director of the Spicers Portfolio Management advisory board. He is also the author of How Much is Enough?
* www.howmuchisenough.net
