Losing your head over money

OVERCONFIDENT - yet with a distinct fear of failure. An urge to look for information that confirms rather than challenges cherished beliefs. A yearning to run with the crowd ...

Sound familiar? It should do - it's probably you.

Legendary US investor Warren Buffett says the investor's greatest enemy is themself. No kidding! Every investor will have their own tale(s) of letting emotions get the better of them, whether it's getting sucked into the hype or failing to cut your losses.

And let's be clear: it's not only the individual the entire market is a bit loony. How else to explain a financial history littered with booms and busts? To believe the market is always rational is like saying people never let their emotions - greed, fear, whatever - get the better of common sense. Once you accept that basic truth, it's time to recognise your own biases and mental rules of thumb, which can lead you to make poor decisions.

Let's start with a basic question: are you a better-than-average investor? Most of us will answer: of course I am. And it's not just amateurs. A survey of 300 fund managers - that is, professional investors - found that 72 per cent of them believed they were better than average at their jobs.

Nothing wrong with a bit of self-belief, is there? In fact, being overly optimistic about one's own abilities is one of the most prevalent mental biases and also one of the most dangerous ones. That's because overconfidence can lead to overtrading, which studies have shown leads to individual investors drastically underperforming the market. So, being realistic about your own abilities is important, yet it's something that eludes most of us. It's also against our nature to be contrarian. Uncomfortable alone, we seek the safety of the crowd, sometimes with disastrous consequences.

Psychologists use a theory known as "cognitive dissonance" to help explain the persistence of booms and busts. It means most of us feel anxious when faced with conflicting beliefs. So, to assuage this feeling, we tend to gravitate towards new information that supports what we want to believe. To get rid of this nasty feeling of dissonance we may also change our previous feelings or thoughts on a subject.

For example, you may have been the most rational of property investors, insisting on a reasonable rental yield before buying. But as the property market inflated, you started looking for reasons to no longer stick to your investing rules: for example, by saying that property was in a "new paradigm" where the old rules no longer apply.

There are other tricks the mind can play on the unwary investor - such as the fact we hate losses more than we like gains, which means we hang on to loser stocks for too long. Another is "anchoring", where we place excessive weight on the original number we see - say a share price - and then make future decisions using that initial figure as a reference point. For example, Company X's share price is worth $50 today. The next day it falls to $40. Often our initial thought is that the shares are now cheap. But how much of that notion is based on the fact you know they were priced $50 the day before? They may well be totally overvalued at $40.

What to do? After all, we're all human - can't do much about that unless you outsource all your decisions to a machine (as some traders do). But for the rest of us, the first step is to recognise that we all fall prey to these psychological quirks every now and then.

Also, writing down an investment plan and strategy, along with a record of your trades and the reasons for them, will give the reflective part of your mind an edge over the impulsive part.

We need emotions to make decisions - as in all things, balance is the key.