Behavioural investing - why investors are creatures of habit

We like to run in packs

Irrational investing can take hold of the most seasoned investor and it’s often because ‘everyone else is doing it’. The share market tech bubble of the late 1990s was a perfect example. Fabulous fortunes were to be made from hi-tech stock and their prices skyrocketed. Huge premiums were paid on companies that had very little underlying value, because everyone believed they would be valuable. In 2002 the bubble burst and the NASDAQ plunged to a six year low.

What this means for current market conditions

Since November 2007 the Australian share market has been volatile. Many investors are experiencing market volatility for the first time and it can be unnerving. It’s a natural instinct to do what it seems like everyone else is doing: selling their shares or investments. This is made worse by media reports and newspaper headlines sensationalising falls: ‘Billions lost in a day!’

Sensation sells

For the media, running stories about billions of dollars being wiped from the value of shares, with graphs of red lines plunging downward, means good business for them but unsettling times for everybody else. It seems like suddenly thousands of investors are much poorer. However, this is not the case. Although the value of some investors’ investments has gone down, investors are only poorer if they sell their shares or investments at a loss. By ‘spooking’ people with headlines – making the herd run – the media can sometimes influence people to make decisions they may not otherwise have considered.

Look beyond the share price

The general consensus is that the economic fundamentals of the Australian economy are sound. The economy here is not close to recession (the opposite in fact). Rather than being blinded by current share prices, investors should look at the company behind the share price and whether it has sound management practices, low debt levels and positive profit forecasts.

The risks of selling during a downturn

While it’s a natural reaction to want to sell your investments during a market downturn for fear of losing more money, investors should always pause and think. Markets continually fluctuate but over time the consistent trend is upward. By taking a long-term view and staying in the market, investors could ride out the lows of the market and access its potential growth. Not being in the market for the full period could mean you walk away from any returns achieved during the period out of the market.

Disciplined investing

One kind of investor that everyone should be, regardless of their instincts, is a disciplined one. This is particularly true of fund managers. Fund managers rein in their natural instincts to ensure their decisions are based on sound research and judgement. A disciplined investor will make sure a portfolio is always balanced and diversified, and generally will not sell their investments at the bottom of the market and will not buy in a bubble. By understanding what kind of investor you are, and ensuring your decisions are based on rational thought, you are more likely to benefit over the long term and achieve your financial goals.

What type of investor are you?

From a behavioural point of view there are three main types of investors. It’s a good idea to work out which type you are. It may help determine what sort of investment decisions you are comfortable with and also what sort of behavioural investment decisions you might make.