27th July 2011
Why? According to psychologists who study "behavioural finance", it could be that the two halves of our brains are not in sync. The left side of our brains is where reflective thoughts occur – so if a company doubles profits, then it is rational to expect the shares will go up in value unless it's a one-off never to be repeated. The left side is for planning, goals, tasks and details.
The right side of our brains, however, is where we do the emotional stuff – where we can easily be distracted, where we can (and often do) make investment decisions with less forethought than tossing a coin.
We all have this dichotomy but understanding that it's there (and doing as much as we can to deal with it) is rapidly becoming a factor that's as important as knowing how the stock market works. "Behavioural finance" is studied by an increasing number of fund managers, IFAs and individual investors.
Markets, it is often said, depend on the balance of greed and fear, and both can often be irrational. When greed is in the ascendant, prices rise. And when fear takes over, everything goes down.
Remember the 1999 dotcom boom? How rational was it to value companies with the turnover of a corner shop, making huge losses with untried business models, in billions? What about those who bought buy-to-let properties that were nothing more than an architect's drawing in places they had never heard of, let alone seen? And two decades ago, someone calculated from Japanese land values that the Canadian embassy in Tokyo was worth more than the entire Canadian stock market.
These – and countless other items – are irrational where our right side emotions take over from our left side rationality. All investors know property prices cannot go up for ever while companies that never make money must go bust.
But investors who understand the irrationality of others might have done better. By studying past bubbles, they would have discovered that they rarely last more than a year or two. So those with the rationality to be early in and early out (even if that meant missing peak prices) can make a profit.
A recent book "What Investors Really Want" by US behavioural finance expert Meir Statman points out that "we want profits higher than risks" – we are all searching for the grail of infinite profits with zero risk. He shows that investors with a better understanding of their own emotions – and those of others – will tend to do better.
So why do we continue to ignore the lessons of our emotions and end up making costly errors? Here's some of the reasons.
There's safety in numbers so if we join with others and go in the same direction, we can't come to harm. Or can we? Herds stampede over cliffs or into raging rivers -the animal equivalent of following the group. The reality is that investors all too often chase up already overblown prices because everyone else is doing it. Eventually the price implodes.
We tend to make financial decisions by "anchoring" ourselves to present day prices. During the past 30 or so years, the price of gold has lost two thirds of its value and then multiplied five times, more recently. But it's the present day price that counts – we anchor our emotions to that, ignoring how previous prices were also seen as "correct". And each new record anchors the previous one. So what is the right value? Is this a bubble waiting for a pin?
Financial products can be complicated – sometimes over-complicated. And outcomes are often impossible to predict. So that's a good excuse to hand over responsibility to someone else. That way, if it goes wrong, there is someone else to blame. The problem could be that the investor is taking advice from someone with the same attitude, who, in turn, is relying on yet another.
This is where you calculate leaving the comfort zone offered by the investment orthodoxy of that day and getting it wrong will cause pain that is so great that it must outweigh the pleasure from abandoning conventional wisdom and getting it right.
Fear of loss – realising losses
The hardest investment decision is selling at a loss even if holding on would increase the pain further. We don't want to admit we made an error so we do nothing in the hope of a turnaround. But our fear of loss – that includes "loss of face" when explaining actions to others – can paralyse us, forcing us to ignore potential gains.
Everyone expects their investments to be better than average. That's impossible – some will be above, some around the mid-point and some below. We tend to believe our choices will return more for less risk than other options. Over optimism also means we ignore left brain fundamental analysis.
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