How Stone Age minds move today’s markets

Two groups of doctors were presented with an operation that could cure a serious disease. The first group was told there was a 7% mortality rate from the procedure within five years; the second that the survival rate was 93% over the same period.

Doctors in the first group were hesitant about recommending the procedure, while those in the second were enthusiastic. Yet the likelihood of survival is identical. Fascinating but how is this relevant to investors?

Well, this study, quoted by Massimo Piattelli-Palmarini in his book Inevitable Illusions, shows the power of what psychologists call "framing" that the way things are presented, even when they are hard facts, influences how we react to them. Sellers of financial products know this too better to tell a prospective client that they have a 75% chance of making money than a 25% chance of losing it.

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Combine framing' with people's tendency to have an over-optimistic view of their own competence (a Princetown University study found that nearly 70% of drivers rate themselves above average) and you start to realise why we make so many apparently obvious investment errors.

To followers of "behavioural finance", it's simple. We are fundamentally unsuited to investing, thanks to hard-wired "fight or flight" survival reflexes acquired from our Stone Age ancestors, who needed them to hunt down the next meal and avoid becoming something else's. As Bill Bonner observes in Mobs, Messiahs and Markets, "we're far more beholden to biology than we think".

The world has moved on, but the average human brain hasn't. Stockmarkets, far from reflecting the considered actions of logical profit-maximisers, as "efficient market" theorists would have us believe, are actually at the mercy of irrational crowds driven by pre-programmed emotions and responses.

This explains why some investors spurn fundamental analysis (focused on ratios) to follow charts (focused on trends). I may be able to prove that a share is cheap, based on detailed ratio analysis, but behaviouralists would argue there's no point in buying it if everyone else is panicking about a looming recession and dumping shares indiscriminately. Mine will plunge too and no amount of protest about "value" on my part will make a jot of difference.

But surely I'll be right eventually? Yes, but as John Maynard Keynes observed, "the market can remain irrational longer than you can remain solvent". So while value investing can be a useful way to choose stocks, understanding investor psychology can help you to know when to buy them. Here are a few tips on how to get around our mental hard-wiring and avoid some expensive investing errors.

Relax don't trade too often

As Kevin Godbold points out on Motley Fool, many investors approach the stockmarket with "caffeine-fuelled urgency and a fear of missing opportunities". The more time you spend glued to a computer screen, analysing every snippet of news for clues about the direction of the market, the more likely you are to react unnecessarily to short-term events.

Why? Because, as Jason Zweig observes in Your Money and Your Brain, a red signal on a news screen showing falling prices induces the same gripping fear that made our ancestors flee from predators. The danger is you panic and sell in haste, only to regret it later.

So, rather than being buffeted and influenced by a constant barrage of information or "noise", as Godbold puts it from the financial media, keep investing simple. Knowing what you want is key to this after all, if you know that you are buying a share or fund with a five-year view, then checking its performance every day seems pointless.

So set your investment objectives and risk appetite; this includes asking yourself questions, such as what are you investing for, what's your timescale, and what kind of return do you need on the money? Then buy shares that look competitively priced.

Keep others that you like, but are more expensive, on a watch list for later and then monitor your portfolio at set intervals. That way you avoid becoming a hostage to your computer and your instincts.

Avoid inappropriate benchmarks

All too often people wrongly assume that benchmarks that matter to them, such as the price they paid for an asset, or the length of time that they have owned it, matter to anyone else. They don't the market doesn't know that you bought those shares for 50p each, ten years ago it only knows what it thinks they are worth today.

Another danger is assuming, despite all the warnings received to the contrary, that the past is a useful benchmark for the future. A good example of both of these mistakes is a friend of mine's refusal to accept a recent offer on his house. He needs to sell, but argues that the offer "is only slightly more than I paid and I have had it for two and a half years, so it must be worth more than that". That kind of thinking could lose him serious money in today's sliding property market.

Admit when you're wrong

No one likes to admit to mistakes. Investors compound this problem with another not recognising successes and taking profits early enough. Investing is all about suppressing emotions don't hold "favourite" or "pet" stocks, only hold winners and take rational decisions about when to bank profits (setting a target return helps).

It's also vital to cut losses having bought technology funds in November 1999, I was disappointed, not to mention embarrassed, to lose 25% within six months as the dotcoms dived. I sold out, reckoning that sentiment had turned against technology shares. Had I stubbornly clung on to them I would still be down around 55% today.