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23 Jul 2009

The Psychology of Investing

Investing is a human endeavor and, as such, it may be fallible. This is not because investors are uninformed or unskilled necessarily, but rather owing to the fact that there are several human behavioural traits which influence investment behaviour and about which investors should be aware.

In its simplest form, investing is about fear and greed.  It is the fear of losing and missing out on gains. It is the greed for more, and the utility that more brings. And so it is that the very psychology of investing deserves exploration in greater depth.

Most of us are inherently social beings and we seldom relish being outsiders. There is safety in numbers, but this can sometimes makes us do silly things - investors of all types can be susceptible to this herd mentality. This is the fear of having a result different (or worse than) the crowd, or of taking a contrary position that does not pay off.

Herd mentality manifests in many ways, not the least of which is chasing perceived winners after the fact.  When everyone else seems to be piling into an investment, one might feel the fool for missing out and so one joins in.  The risk here is that of buying high, which is often followed by the further mistake of selling low, rendering a destructive capital loss permanent.  Well-considered contrarianism is more likely to be rewarded over the long term.

People are often unjustifiably optimistic when the market goes up and they fail to adjust their exposures accordingly.  Equally, they are more negative than they should be when the market goes down and they fail to see buying opportunities. 

The evidence of this is borne out starkly in the quarterly unit trust statistics – money market funds are very much out of favour near the top of bull markets (precisely when investors should be cautious about riskier asset classes). Conversely, allocations to money market funds appear to predominate at the bottom of bear markets, and often well into subsequent bull phases.

Also, many investors are afflicted by overconfidence, which can make them trade too much and so under-perform the market.  Trading or switching also carries a cost and costs erode wealth.  Eliminating unwarranted costs is a certain means of increasing one’s wealth over time.

It is an open secret that these sorts of behaviours are what make the market irrational and inefficient (a heresy in some investment circles).  So with all this stacked against us, how do we invest successfully? Adding a healthy dose of science and a dash of art might be the answer.

Science in investing can be many things, but in this instance, it is having a tried and tested process that has been subject to much scrutiny and extremes.  The art is having an innate understanding that emotions often drive the markets, and having the discipline to try to remove some of the behavioral fallibility.

The cynic might argue that not only are investors bewildered by a plethora of often unnecessary choice in investing, but now that bewilderment is compounded by a battle against innate human characteristics.

In an environment that apparently thrives on complexity, simplicity may be a panacea of sorts.  It is comforting to know that there are a few fund managers with long, consistent track records of excellence who have weathered the many storms of market vagaries and behavioural oddities – it is those managers that you should seek out.  Furthermore, burdening yourself with the management and maintenance of a portfolio of specialist funds could well invite the behavioural devil to the door – we have long advocated putting your faith (and your investments) in a well-managed asset allocation fund. 

Ends.

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