Fool your brain and boost your returns

The biggest challenge facing most investors is simple: they are just not very good at it. In the 20 years to 2008, the S&P 500 gained an average of 8.4% a year. However, the typical investor earned just 1.9% a year, according to a US study cited by The Motley Fool. It's not down to a lack of knowledge. In fact, research by Lauren Willis at Loyola Law School found that an education in finance "appears to increase confidence without improving ability, leading to worse decisions". No, the real problem is that our brains simply aren't built for investing. We are hardwired to make some crucial errors that hamstring our attempts to make money. Here are threeof the more common mistakes we make, and tactics for avoiding them.

1. The feast and famine problem

As the Psi-Fi blog notes, certain key "evolutionary adaptations designed to aid our survival in prehistory are dangerous in modern life". For example, our hunter-gatherer ancestors would never have been quite sure of where their next square meal was coming from, and hunting for food took effort, not to mention risk. So eating more than our fill when the rare opportunity presented itself made sense. The modern Western consumer, on the other hand, has no need to fear hunger. Food is easily attainable: "the risk side of the risk-reward equation" has been turned off, as it were. Yet we still "eat as much as is put in front of us", regardless of how full we are.

The same instinct can be seen at work in stockmarkets when bubbles form. Once euphoria takes hold, whether in technology stocks, housing, or precious metals, "people forget about risk, because everyone else does, and gorge themselves stupid". Investors chase already expensive stocks higher, making the eventual fall-out from the bust worse when it arrives.

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2. Pride comes before, and after, a fall

One of our biggest problems as investors is that we hate losing more than we enjoy winning. That leads us to hang onto loss-making positions long after they should have been liquidated, in the hope that one day they will come good, because as long as we don't crystallise the loss, we don't have to acknowledge it. That's despite the maths working against us for example, if a share price falls by 50%, it needs to double to get you back to break-even.

Sometimes we even make an initial mistake worse by buying on the dips'. I've done it: having bought the Henderson Technology Fund in 1999, just before the dotcom bubble burst, I watched it fall by 25% as the boom turned to bust. I should have bailed. Instead, I sank another £2,500 into the fund and watched the price fall further still. Why? Pride and a stubborn belief in my original flawless analysis of the technology sector. A humble recognition that I'd got my timing wrong and should just cut my losses would have saved me a lot of money.

3. You've been framed

In a 1974 study by psychologists Daniel Kahneman and Amos Tversky, titled Judgement Under Uncertainty, a wheel with the numbers 1 to 100 was spun. Volunteers were asked first if they thought the percentage of African countries that were members of the UN was higher or lower than the random number generated. They were then asked to estimate the actual percentage of UN membership accounted for by African countries.

The researchers found that the random number influenced the answer to the second question (if it was low the estimate tended to be low), even although it was entirely irrelevant and even though the study participants understood this.This tendency to cling onto a reference point, regardless of whether it has any logical relevance to the decision in hand, is known as anchoring'.

Say you buy a share for £2.50. It shoots up to £4 amid a series of large contract wins. You debate selling, but decide not to. Not long after, the price drops back to £3 after the director responsible for those wins is poached by a rival company. Your problem now is, can you accept that the recent high of £4 is a historical value, based on a different set of circumstances? Or will you anchor' your expectations to the £4 price, and refuse to sell until the stock hits that level again which may never happen? The rational thing would be to look at whether the share is now good value or overpriced at the current level of £3, and act accordingly. But getting your brain to accept that isn't easy.

How to use your brain

To become better investors we have to trick our brains into not doing many of the things they have evolved to do. Here are three steps that can help.

First, develop an investing rationale and stick with it. For example, Stephen Bland, who writes the Dividend Letter newsletter for MoneyWeek, screens stocks according to dividend yield. Other investors may use price-to-book or price-to-earnings ratios or a mixture of screening criteria (see my video tutorials). You'll have your own preference, but the key thing is to use a system that will protect you from the temptation to just jump onto the latest hot headline-grabbing stock or fad.

Second, regularly review your portfolio, and don't just look at your losses analyse your gains too. What did you expect when you invested? How much of your profit was down to luck? What does that tell you about your original rationale for buying, and can you improve your strategy?

Third, have a plan for selling, as well as buying. Sell signals could be numeric you may sell if a stock racks up a 25% loss for example. Or they can be less tangible a big change in management, a takeover, or a big regulatory change. In short, by making investing as systematic as possible, you might just stop yourself being undone by your instincts.

This article was originally published in MoneyWeek magazine issue number 541 on 10 June 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.