Investing wisely isn't easy at the best of times. Now the credit bubble that lifted pretty much every asset class over the past few years has burst, it's becoming even harder. But an investor's main concern shouldn't be the credit crunch, or the housing crash, or inflation. As Benjamin Graham put it in 1934, "the investor's chief problem and even his worst enemy is likely to be himself".
Modern finance theory assumes that investors are rational. They'll always do what makes the most sense from an economic point of view. It doesn't take a genius to realise that this is a massively idealised view of investment investors make mistakes all the time, and act in ways that seem anything but rational.
The good news is that if you're aware of your human flaws, you're more likely to be able to compensate for them. Here are three behavioural glitches' that investors should be aware of.
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1. Fear of losing
No one likes losing. But it may be a surprise to learn that we hate losing far more than we love winning. This is based on the findings of prospect theory', developed in 1979 by psychologists Daniel Kahneman and Amos Tversky. They found that people value gains and losses differently. For example, people will be happier with the idea of gaining $50, than with the idea of gaining $100 and then losing $50, even though the end result is the same.
There's nothing wrong with this fear of losing. After all, most successful investors point out that avoiding losses is one of the keys to investing profitably. Unfortunately, our fear actually makes this harder. Investors will take profits too early, reluctant to risk losing any gains they have made. On the other hand, they don't want to crystallise any losses, and so prefer to hold onto losers in the hope that one day they'll come good again.
There are a couple of things you can do about this. One is to have specific targets for the return on your investments, and a specific loss threshold below which you will sell. The other is to avoid checking your portfolio too frequently. That way you won't feel the pain of every fall as the market reacts to short-term news.
Kahneman and Tversky coined the term anchoring' to describe the way that we tend to base our our thoughts around one piece of information when making decisions. That would be fine as long as the information in question was relevant. The trouble is, we actually anchor to just about anything, particularly when we know little about the subject we're making a decision about.
The main criteria for choosing an anchor include how recently we saw it, and how easily accessible the information is. This is one reason why bull and bear markets both die hard. There are always investors who have attached their expectations to the top or bottom of the market. So when values drop or rise, they are ready to buy on the dips' or sell into strength'. The trouble is that they are using the wrong metric to measure whether the market is good value or not.
For example, take all the buy-to-let investors now turning into mortgage rescue' specialists. They think that by buying a desperate seller's property for 20% below the ostensible market value, they are snapping up a bargain. In fact, they're anchoring their expectations to a value that only occurred at the very top of the market. A more sensible metric to rely on would be the long-term average of earnings multiples to house prices, which would almost certainly reveal that even 20% is still paying well over the odds at current levels.
This is why fundamental analysis is vital. Look at the p/e, the price to book value ratio, and work out if a stock really is cheap. Back it up with some technical analysis by all means, if that's your thing. But don't think that just because an investment is sitting below an all-time high that it will ever reach that high again. Stockmarkets around the world, from the Nikkei 225 to the Nasdaq to the FTSE 100, are testament to that.
3. Twisting the facts to fit
Human beings like to find patterns and form theories. It makes the world seem a more predictable place. Predictability is a very comforting idea to cling to in an uncertain world, so it's nice when events confirm our expectations. Conversely, it's uncomfortable when reality doesn't fit in with our views. Psychologists call this cognitive dissonance' and, like all uncomfortable sensations, most of us would rather avoid it. But such avoidance leads to confirmation bias', whereby we only look for evidence to support our theories and ignore the facts that don't fit into our big picture.
How does this affect our investing? Well, it's even easier to ignore contradictory evidence if almost everyone else has the same opinion as you. But you can almost guarantee that if this is the case, then you're just part of a herd chasing an asset ever higher. If you find that your reasons for buying an asset require ever more contortions to fit with reality like the idea that profits don't matter anymore, prevalent during the tech boom then you probably need to rethink your views.
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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