Fear or greed?

Quickly try to answer these off the top of your head.

How many seats are there in the Senate?

How many bones are in your body?

How many states are in Australia?

You know the answers to these questions - right?

While everyone thinks they know the answers, there is an unusually large margin of error when it comes to answering questions every high-school student knows.

It is traits such as overconfidence that give us an insight into the field of behavioural finance - an area that attempts to analyse how people make their choices and explain why we engage in irrational behaviour.

Consider this: gamblers continue to put coins into poker machines even though years of experience tells them they are unlikely to come out ahead.

At the same time, we know we should save more for retirement but only get around to it when it's too late.

Like a long-standing promise of going to the dentist or stopping smoking, if we make irrational decisions in daily lives - the theory goes - we are likely to carry the same irrational decisions into the way we go about investing.

In the way we think we know the answers to the questions above, we think we have a diversified portfolio or are holding the best stocks.

MYTH OF EFFICIENT MARKETS

Even if the portfolio is "diversified", the chances are it is mostly in domestic shares and we are missing out on a whole variety of asset classes, from bonds to alternative investments or property.

This is particularly relevant in self-managed super funds, which now make up the largest sector of the nation's superannuation industry.

Figures from the recent Cooper review show that the asset allocation of self-managed super funds are concentrated in Australian equities and then cash.

"If you've got one asset class, that's no problem. But you are going to have to handle extraordinary volatility and the average investor can't handle the volatility," says George Boubouras, the head of investment strategy with investment bank UBS.

On average, the Australian equity market has been negative every 3 years since 1958.

The highest yearly return during this time was 66.8 per cent in 1983.

The lowest was minus 40.4 per cent in 2008 during the depths of the financial crisis.

If you were to hold a single stock showing that kind of volatility, chances are you'd think twice about it.

Until the mid-1990s, behavioural finance was largely seen as an exotic branch of psychology.

But in 2002, the field hit the mainstream when American psychologist Daniel Kahneman was awarded the Nobel Prize in economics for his earlier work on the prospect theory - examining the way people handle uncertain rewards and risks.

Kahneman and co-author Amos Tversky found that people put a lower value on results that were merely probable in comparison with those obtained with certainty.

EMOTIONS RULE

Under Kahneman's prospect theory, the individual is likely to assign more value to gains and losses than to final assets. In other words, people are likely to be more influenced by short-term volatility in the value of their investments than focusing on the final value or the longer term returns.

Kahneman also argued that the ways alternative scenarios are framed - not simply their relative value - can greatly influence the decisions people make.

The conclusions flew in the face of utility theory, the standard assumption among economists that investors or consumers are driven by rational decision-making - the underlying driver of an efficient market.

But, as seen in someone who has bought something on impulse or clearly paid over the odds for a house, humans do not behave like the rational beings economic theory says we are.

"We have a lot of behavioural biases and are emotional when making decisions," says UBS's Boubouras, one of Australia's experts in the field of behavioural finance.

Which of the following scenarios would you choose?

- A sure gain of $100,000 or an 80 per cent chance to gain $125,000 and a 20 per cent chance to gain nothing.

What about if you faced this choice?

- A sure loss of $100,000 or an 80 per cent chance to lose $125,000 and a 20 per cent chance to lose nothing?

Most would opt for the safer alternative and not take the chance - this is risk-aversion in practice. That is, avoiding risks if the profit is not big enough compared to the safer option.

BAD CALLS ARE COSTLY

Experiments by Kahneman suggested people would start taking on risk if the prospective winnings were at least twice the possible losses.

The second question relates to how people deal with losses as well as playing on the notion that we can't deal with losses. So when it comes to the chance of losing nothing, people will still rather take on some form of risk, rather than a certain outcome of losing something.

Depending on the conclusions reached, this would go a long way in tailoring an investment portfolio based on the way we handle losses and our appetite for risk.

Boubouras trained in behavioural finance at Harvard University and, through his career as an economist and fund manager, he's seen first-hand what he describes as irrational behaviour.

During the 1997 Asian market crisis, Boubouras was based in Hong Kong managing an Asian equity fund on behalf of Australian investors.

Clients back in Australia were calling on him to liquidate holdings in solid Asian industrials as sharemarkets in the region were falling.

More than a decade later Asia remains the growth engine of the global economy.

Then, as the financial crisis hit Boubouras says, too many investors were panicking, making the wrong decision at the wrong time.

CHECK VOLATILITY RATES

"In the first quarter of 2009, people removed themselves from their long-term investment planning and would say things like, 'I just need to sleep at night, I can't handle this any more'," he says.

"No matter how much time you spend with clients to say, 'Look, your portfolio has done OK, they are quality assets', they just sell it all and go to cash. So that sets them back a decade from their retirement plan and they become miserable in the long run."

Boubouras often surveys his clients asking what type of returns they would think acceptable.

During the market boom of the last decade, expectations were about 17 per cent. Since then, the expectations of his clients have pulled back to about 10 per cent in tougher equity markets.

Even though the expectations of returns have been lowered, a 10 per cent yearly return comes with a volatility rate of 15 per cent.

And the closer you look, the more loss you will see in your portfolio. The probability of seeing a positive return over one year is about 75 per cent, or an investor will experience a loss once every four years.

For every quarter, positive returns come in at 63 per cent or an investor will experience at least one loss each year. The probability of seeing a positive return over one day is about 51 per cent, or an investor will experience losses 123 days each year.

"If I was to have 123 negative trading days, at the end I'd be frazzled. I'd be a walking wreck," Boubouras says.

"So, with the 10 per cent expected return, can you handle this volatility? If you can't maybe you should lower it."

BEHAVIOURAL TRAPS

Like most super fund options, investors can be grouped into three portfolios: conservative, moderate and aggressive.

Based on the models prepared by UBS, the aggressive portfolio, mostly made up of domestic and international shares, is designed to deliver higher returns over time.

However the volatility will be much higher from year to year - especially on the downside.

At the other end, the conservative portfolio has the biggest single exposure to bonds. The portfolio will deliver lower long-term returns but any losses from year to year will be substantially capped.

The forces of irrational behaviour can also be seen in investment markets. At the time of writing, BHP Billiton shares are selling at the equivalent of a 15 per cent discount in London compared to Australia, even though they are shares in the same company with the same earnings and dividends.

Shares in listed investment companies such as the Australian Foundation Investment Group or Argo Investments rarely trade at the relative value of their investment portfolio.

Seeing markets rise and fall generates all kinds of emotional responses. In bull markets, investors experience optimism to excitement to euphoria as they see their portfolios grow.

But as bear markets set in, this quickly turns to fear, panic and despondence.

So for the canny investor, the biggest financial opportunity exists during periods of despondence. Likewise, times of euphoria pose the biggest financial risk to investors.

Other emotional responses can be seen when equities markets surge during a single session. While this rally brings on optimism, what many tend to forget is that it is equally bad news for our bond portfolios, which would most likely be down.

Investors can also fall victim to their own behavioural traps. These include overconfident investing, which implies an overly optimistic assessment of knowledge of a situation.

Overconfidence can be seen as detrimental to stock picking in the long run, largely because overconfident investors tend to trade too much.

GROUP THINK

Previous studies, including those by researcher Terrance Odean, concluded that traders with the most turnover on average received significant lower returns than the broader market.

Other traps for investors involve succumbing to herd behaviour.

This can be witnessed in operation during all asset bubbles, be they in internet stocks or the listed infrastructure stocks.

Here the argument often comes down to the unlikelihood that such a large group of people could be wrong - even if you are convinced that the course of action is irrational.

Think of investing in an internet stock that has no earnings or business model to speak of.

Even professional fund managers are vulnerable to herd behaviour, which is not a very profitable investment strategy.

Other behavioural pitfalls for investors include selective perception, in which we rule out information that goes against our own opinions ignoring lessons from the past and investing in stocks that are close to home.

Still, behavioural finance has its critics, namely supporters of the efficient markets theory, which underpins modern financial markets.

Led by American economist Eugene Fama, this theory discounts irrational behaviour because it argues that prices of financial assets accurately reflect all the available information about economic fundamentals.

Therefore shares in Commonwealth Bank will rise if the bank releases a better-than-expected profit likewise, a disappointing result will see shares fall.

For those readers who picked 206 bones in the adult human body, 76 Senate seats and six Australian states, you are probably comfortable with the idea that equities as an asset class will offer the highest expected returns over time but also the highest volatility.

For the rest of us, it might be time to diversify.

The seven behavioural traps of investing

- Selective perception: ignoring information that contradicts our own opinion.

- Herd instinct: doing what everybody else is doing.

- Loss aversion: selling winners too soon and losers too late.

- Overconfidence: trading too much.

- Ignoring lessons from the past: "It is different this time."

- Home bias: not looking beyond our own market.

- Lack of diversification: too much concentration in one area.

Guard your actions

Ways to minimise behavioural bias:

- Use fundamental analysis to make decisions.

- Limit trading of investments that are speculative.

- Realise losses where they fall, but don't throw good money after bad.

- Use a long-term financial plan and stick to it.

What type of investor are you?

- Based on what level of return you want and what level of risk you are prepared to tolerate.

- Diversification will lower the volatility of portfolios and you will exhibit less negative periods the more conservative you are.

But your expectations of return need to be lower.