Arun Abey: Market-watchers left in two minds

Successful investors avoid being swept away by the emotions of euphoria or gloom. Photo / Bloomberg

Notwithstanding the increasing severity of the global financial crisis, it is now clear that markets have over-compensated on the way down. A bubble in confidence stimulated by a boom mentality has been replaced by the depths of gloom.

In this type of environment, ideas such as the "fair value" of stocks and economic fundamentals are temporarily suspended while people's actions are being driven by sentiment.

Research has shown the investment behaviour of the average individual has a much greater impact on their long-term results than the behaviour of the funds they invest in. While fund managers and financial advisers demystify investment selection and performance, they can

never eliminate the complexity of markets and the resulting psychological traits unleashed in investors.

In his book The Ancestral Mind, Dr Gregg Jacobs, an assistant professor of psychiatry at Harvard Medical School, provides insight into such behaviour.

Dr Jacobs separates the human mind into two: the "ancestral mind" and the "thinking mind" - peculiar to homo sapiens. The ancestral mind is from our pre-verbal past, similar in function to that of a lizard. It is charged with looking after fundamental wellbeing and knows only instinctive responses to factors such as hunger and pain.

The thinking mind is the rational, conscious mind that processes information and complex thoughts. It is this part of the mind that investors draw on to analyse shares, take views on economies and deploy investment strategies. The ancestral mind is, in one sense, what would be left if your thinking mind were switched off. When you take an instant dislike to someone for no apparent reason, that's your ancestral mind at work. When you decide you don't like them based on their actions, that's your thinking mind.

For investors, the thinking mind provides a necessary counterbalance to instinct. But behavioural finance research shows that this counterbalance is less effective than you might expect. For all the good it does, the damaging aspects of the thinking mind usually predominate in markets. It's prone to endless "mental chatter" and gives disproportionate status to negative thoughts, causing self-destructive behaviour in investors.

The thinking mind, for example, does not cope well with surprises, which trigger a fight-or-flight response. While this is useful for survival in the wilderness, it can affect rational decision-making when the latest investment portfolio report arrives in the mail.

Likewise, the thinking mind does not cope well with bad news, daily doses of which are delivered by media that create a distorted reality through "feast" or "famine" headlines. A critical antidote is for investors to make decisions through the lens of their personal financial situation - and worry less about external factors that can't be controlled.

The thinking mind is also behind responses like envy and jealousy. Take the case of the financial adviser who recommended their client avoid a particular fund - call it Murphy's fund - in which the client's neighbour invested. Murphy's fund soars, the neighbour collects the winnings and buys a red sports car. The ancestral mind doesn't care - sports cars are irrelevant to survival. But the red sports car that "could have been mine" sets off what Jacobs calls a "troubling internal dialogue" in the thinking mind that can lead to a genuine stress reaction.

For investors who are motivated by material goals, this troubling internal dialogue is likely to be louder and more persistent - explaining why the wealthiest clients are often the least satisfied. The other significant aspect of these emotions is that, psychologically, they are a "preparation to act" - they move us to make decisions.

In Jacobs' words, "Evolution has placed a higher priority on immediate emotional responses than on thinking, reflecting and planning. If we always had to wait for the thinking mind to determine whether something was dangerous, we might not only be wrong - we might be dead." These are important sentiments for hunters on the savanna but successful investors manage emotions to positively influence their investment decisions.

So, while it's easy to get caught up in the short-term news and events of the global financial situation, a long-term perspective and a healthy dose of optimism can be helpful during these times.

The next 10 days or 10 weeks (or even months) might be difficult to predict with any degree of accuracy. However, taking a step back and looking out over the next 10 years, we can be certain markets will return to growth and investment portfolios will recover.

Having noted this, investors must not lose sight of the fundamental truths such as "stay diversified" and focus on "time in the market" rather than "timing the market". In fact, it's difficult to recall a time in recent memory when these nuggets of truth have not been more relevant and valuable.

Regardless of the economic environment, the foundations upon which global financial markets are built will continue to fulfil their purpose. Businesses will continue to generate profits, consumers will continue to buy goods and services and people like you and I will continue to seek advice on the sensible investment of our capital. Being aware of, and keeping a check on, the thinking mind will go a long way towards achieving positive, long-term investment returns.

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