How to beat your emotions when investing

Investors are their own worst enemies. For proof of this, you need look no further than a bizarre statistic highlighted by Jeff Fischer on the Motley Fool website. Between 2000 and 2010, the best performing US mutual fund was the CGM Focus Fund. This fund managed to deliver a return of 18% a year on average, during a period when the American market the S&P 500 was essentially flat. That's impressive.

Now take a guess at how much the average investor in the fund made over the same period. You'd think they'd be laughing, right? Wrong. According to Morningstar, over that same period, the average investor in the CGM Fund lost yes, lost 11% a year.

How on earth did they manage it? It's all down to investor psychology. We all think we are cleverer than we really are and so try to time the market. As Fischer points out, the fund soared by 80% in 2007. As a result, lots of investors piled in, just in time to endure a 48% fall in the 2008 crash. They then limped back out of the fund, only to miss the 2009 rally.

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It's not just down to CGM investors being unlucky. A study from Davis Advisors notes that between 1991 and 2010 the average fund owner earned 3.3% a year, even though the average fund made 9.9%. So while we may criticise fund managers for being expensive (and they are), it doesn't help that we compound the effect by being pretty woeful at managing our emotions. So what's the solution?

The problem boils down to our tendency to chase performance. So when fund managers (or individual themes and sectors) are doing poorly, we ignore them, instead chasing hot' stories and the funds that are investing in them. That's a mistake because, as the Davis study shows, over a ten-year period even the best fund managers spent at least three years ranked in the bottom 10% of the study. So if you just end up chasing last year's winners each time, you're almost certain to lose money consistently. You'll always be buying high and selling low the opposite of what you should do.

The trick is to discipline yourself not to trade too often. This starts with making sure your decision to buy in the first place is well researched, so that you are confident in your choice. Then, once you've bought, don't hover over its performance figures day by day review its performance perhaps annually if you can, and certainly no more than quarterly.

Also, if you are choosing funds, then try to find ones that abide by similar principles. You want funds that hold a relatively low number of stocks (the fact sheet is a good starting point to find out about this), and so are less likely to churn' (over-trade) their portfolios and incur extra charges. And if you are just investing in something simple, such as big UK blue chips, consider using a cheap index tracker rather than an actively managed fund. As Terry Smith, CEO of Fundsmith, puts it in the Financial Times: "given that the average fund manager underperforms the benchmark index anyway, why would you pay more?"