Focus on opportunities but watch your step

But people can be funny creatures. Behavioural finance (that's the study of what people really do with their money as opposed to what the economists assume they will do) tells us we feel more pain from losing money than pleasure from making it.

We don't like admitting we were wrong - that's known as regret avoidance - so we tend to hang on to our losers longer than is rational, while being much more willing to sell our winners.

We tend to be overconfident about our own investing abilities. And the more we trade, the more overconfident we tend to be. (Studies have shown that men are far more prone to overconfidence and trading than women, and as a result, they are more likely to suffer losses. That's one for the girls.)

But volatile markets are no place for overconfidence or other irrational forms of decision-making. While there are opportunities in even the most dire markets, there are also traps. Let's look at just a few of them.

Yield trap

In volatile times, the only certain component of sharemarket returns is dividends, right? You bet.

They might not fully compensate you for a big dip in share prices but they can cushion the fall, and logic attests that companies paying a regular income stream will recover faster than those offering nothing more than promises.

But that doesn't mean anything with a high dividend yield is a good investment. In uncertain economic times, it is the sustainability of that dividend that is critical. If there are doubts that a company can maintain its dividend, it is likely to be hammered - and indeed, the high current yields on some stocks have more to do with the market's belief that they can't keep paying than indicating a solid investment.

A consistent track record of paying distributions is a good start. A record of growing them is even better. But a portfolio manager with Prime Value Asset Management, Shih Thin Wong, recently argued that in the past two years, there have been numerous continuing structural changes affecting Australian companies that will inhibit their ability to generate profits - and dividends. The shift to online shopping and the high Australian dollar for exporters are examples. But rather than its current yield, what matters is whether a company is likely to generate future cash flow and dividends.

Index fund trap

Let's face it. Even in a raging bull market, you've got better things to do with your money than give 2 per cent of it each year to a fund manager just so it can replicate the index.

If you wanted index performance, you could get it for less than half the price through an index fund or exchange traded fund.

But research company van Eyk says that in a volatile investment market, it is more important than ever to choose fund managers that have a greater capacity to outperform the market.

It looks for managers with a high tracking error, which, in lay terms, means they don't provide returns that are close to those of the index.

While you would want a fund that performs better than the index (not worse), the managing director of van Eyk, Mark Thomas, says too many investors are encouraged to invest in funds that produce market-like returns. If you have a few of these funds in your portfolio, he says, they could cancel out any additional returns generated by a fund manager that doesn't hug the index.

Thomas says when funds with a low tracking error are combined with a market that's volatile and lacks a long-term trend, investors basically end up paying higher fees for an index strategy. Returns are too hard to come by to justify that.

Cheap stock trap

How often do you hear investors claiming a stock is cheap on the basis of what it used to be worth?

Welcome back to behavioural finance, where the experts have identified the human instinct for anchoring as one of the causes of irrational behaviour.

Put simply, when asked to predict what will happen in the future, most people make estimates starting from a value that is already available. So instead of looking forward, we base our judgment on what a stock was worth previously.

That might be fine if none of the company's business fundamentals have changed and the stock price has fallen because of an irrational market blip, but that is rare.

All too often, a stock is trading at half its former price because its profit potential has taken a hit, or because the market realised it was never worth the price accorded it at the top of a bull market.

Value has to be measured in terms of the company's future outlook, not what it may have been worth.

Interestingly, however, anchoring can also work against investors recognising the signs of a recovery.

When we become accustomed to bad news, we tend to base our decisions on that and expect more - even though the tide may be turning.