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investment advice - you can't read this too many t

  1. This is a bit long ... but worth the read for those who don't have an iron clad trading strategy. Just wish I could put it in practice!!

    Dollars & sense
    Annette Sampson | January 22 2003 | Sydney Morning Herald (subscribe)


    Why you can't trust your instincts if you want to be a successful investor.


    Ok, so we all know investment markets can be cantankerous and irrational."In favour one day, on the nose the next" has pretty much been the investment credo of the past couple of years.All these ups and downs (especially the downs) have left many of us feeling like we're dealing with an erratic and tetchy relative rather than with rational investments.

    But hold on a second.Is it really the markets that are at fault? There's a growing body of research that shows investment markets are never going to be rational because they are merely the result of investors thinking with gut instincts – many of them a hangover from our days back in the caves – rather than logic.


    Why we think the way we do

    Much of the wiring of the human brain was developed when we had little more to ponder than where the next meal was coming from, finding a mate or which way to run when confronted by a sabre-toothed tiger. Civilisation is a recent innovation in the evolution of mankind.
    In the US Money magazine recently, the American neuroscientist, Read Montague, described the human brain as a Maserati when it comes to solving "ancient" problems such as recognising short-term trends or generating lightning-fast emotional responses.The fight-or-flight instinct, for instance, is automatic because it's wired into the nether regions of the human brain.But in Montague's view, our minds aren't as good at more modern problems such as recognising long-term trends or focusing on several factors at once. Our ancestors didn't have to do these things, though we do every day.

    The unfortunate truth is humans are psychologically programmed to be investment dunces – to buy high and sell low, to chase last year's "hot" sector and to think they're smarter than the average investment analyst complete with PhD.Put us all together and it's much easier to understand why markets behave the way they do – why they build up steam the more overpriced they become, why predictable but otherwise boring stocks can trade at high price-earnings ratios, and why stocks that deliver unexpected profit downgrades get savaged far more than their bad news is worth.

    "When investors have their wealth at stake, their primitive instincts can take over," says Dr Shane Oliver, chief economist with AMP Henderson Global Investors.



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    "You see fear and greed, and fight or flight.They just want to be in or out.But when it comes to other things where the gains or losses aren't as apparent, they don't behave in the same way.If the price of cars goes down, everyone celebrates.But if share prices fall, everyone focuses on the loss of wealth."

    The study of investor psychology – or behavioural finance, as it's also known – got a shot in the arm last year when the US cognitive psychologist Daniel Kahneman won the Nobel prize for economics for his work in this area.Kahneman and his late partner, Amos Tversky, showed humans are simply incapable of fully analysing complex decisions when the future consequences of those decisions are uncertain.What we do is rely on short cuts or rules of thumb.

    Our inability to predict the future sends our financial decision-making processes haywire.So instead of approaching the decision logically, we rely on quick fixes such as hot tips, the latest news events and even what the guy next door is doing to solve the problem.


    Curbing the habits

    As with other irrational behaviours – such as phobias, addictions and emotional hang-ups – the first step in fighting them is to be aware you have them.
    "Successful behaviour can be developed," says Mind Over Money educator Lois Keay-Smith."By being aware of some of the things you may automatically do, hopefully you can check yourself before you act on impulse." But Kahneman warns our way of thinking is incredibly deep-seated.

    Have a look at the two lines in the diagram below. Which one is longer? Kahneman says humans are programmed to believe the left-hand line is longer – they are actually the same length.Even if we measure the lines, our mind keeps telling us one line is longer. "Merely learning about illusions does not eliminate them," says Kahneman."The goal ...is to develop the skill of recognising situations in which a particular error is likely.In such situations, intuition cannot be trusted and it must be supplemented or replaced by more critical or analytical thinking."

    Similarly, look at the optical illusion opposite.There aren't black dots between the squares but you can't avaoid seeing them.


    Einstein, you're not

    Ego is one of the basic drivers of the human mind, and there's a substantial pool of evidence that says investors are full of it.Coupled with our inherent optimism, that can be a dangerous thing.
    How good a driver are you? Most people reckon they are above-average drivers – even though, averages being what they are, a sizeable number of people must be wrong.Keay-Smith says a similar question was once asked of a group of American MBA students: how many of them thought they would finish in the top half of the class.The response: 100 per cent.

    Translate this to the investment arena and it's easy to see why so many of us believe we can outperform the market, that our DIY super fund can beat professionally managed products, and why so many of us believe investment basics such as diversification are for other, less smart people.

    The problem, says Kahneman, is that optimists overestimate their ability to control their own fate.

    They tend to dismiss the role of chance and instead credit skill for lucky windfalls.A little knowledge can be a dangerous thing.

    Research by Professor Terrance Odean at the University of California has shown overconfidence typically leads to increased trading by investors – and increased trading leads to poorer results.Keay-Smith says in one study men were found to trade 45 per cent more than women but earned 1.45 per cent less; single men were 67 per cent more likely to trade and earned 2.3 per cent less.

    Suggested countermeasures: Always consider the downside and be aware of what you don't know.

    Kahneman suggests that, because we're more likely to remember successes, we should keep a list of failures to ensure we learn from them.

    Diversify.It may not control your sense of omnipotence but at least you'll be spared the pain of putting all your money in that great deal that goes wrong.The more you can put your investments on autopilot, the less risk you'll crash them.

    Avoid the common pitfall of overreacting to every piece of news, but by the same token, don't ignore news that contradicts your earlier decisions just because you don't want to hear that you might have been wrong. And bear this in mind: it's better to do nothing than something.In fact, Kahneman told the Davos summit last year that the cost of having an idea (something that motivates you to buy or sell) has been shown to be 3.5 per cent.As Geoff Davey, managing director of ProQuest, puts it: "If you're in quicksand, don't wriggle."


    Losing your way

    One of the key tenets of behavioural finance is that incurring a loss hurts the average investor about 2.5 times as much the pleasure they get out of making a profit.That leads inevitably to loss aversion – we loathe cutting our losses and admitting mistakes.
    Even more importantly, it leads to regret which Kahneman says intensifies the pain of losing.He says investors also place undue emphasis on hindsight and believe events are much more predictable than they are.

    So what seemed a sensible risk at the outset often becomes a blindingly obvious mistake that should have been avoided after the investment has made a loss.

    (To make matters worse, we're just as inclined to regret missed opportunities as we are losses.Davey says this helps explain why people invest in things they know are probably unwise.That rational thought is overridden by a fear they might "miss the boat".)

    Investors often try to avoid regret by employing financial advisers (who cop the blame if there's a loss), going with the herd (it hurts less if everyone is losing money), or investing on past performance.

    Davey uses the example of Bill and Bob.Both have a portfolio of five investments.Each of Bill's investments had risen by $100 over the past year, giving him a total gain of $500.Bob's investments have been mixed – some are up, a couple are down, but overall he is also $500 in front.The problem, says Davey, is that while Bill will be pretty satisfied with his investments (and his adviser), Bob will focus on the loss-makers in his portfolio.And human beings being what they are, Davey reckons it's odds-on Bob's financial adviser will get an irate call wanting to know why he put him into the losers.

    Keay-Smith says this fear of losing makes us hold onto dud investments rather than selling, taking the loss and admitting our mistakes.We confuse the "value" of the investment with what we paid for it.

    "The fact that we've paid X for something anchors it," says Davey."That's why you see projects, particularly government projects, going ahead when they should have been canned halfway through.They don't want to waste the $100 million they've sunk in so far, even though finishing the project will be a failure and cost another $100 million."

    Suggested countermeasures: Learn as much as you can about the long-term history of markets, suggests Oliver.Decide on a long-term strategy that is within the "risk tolerance" you're prepared to wear and then turn off.Don't give in to the need to "check" on your portfolio every 10 minutes.Fear is a powerful motivator and panic a great way to lose more.But if a decision is clearly wrong, cut your losses.

    Be just as ruthless in analysing your successes as your failures, says Keay-Smith.Understanding why things happen can help you make better decisions.


    Seeing things

    Davey says one thing we are very good at is recognising patterns.So much so, we sometimes place importance on patterns that are meaningless or not there.
    Too smart for that?
    Which of the following sequences is more likely to occur when a coin is tossed several times – HHHTTT or HTHTTH? According to Kahneman, most people believe the second sequence is more likely to occur – even though both are equally probable.This is because the second sequence looks random while the first appears systematic.

    A 1985 study looked at the perception by most fans that US professional basketball players go through periods when they are "hot".In fact, the study found, the players were no more likely to make their shots when they were "hot" than their long-term average.

    Oliver says we tend to downplay uncertainty and project the current state of the world into the future.

    That's why we think that the shares or fund managers that have done well recently will do so in the future and ultimately why investment bubbles and busts overshoot any levels that seem halfway sensible.That's why, in the absence of better information, we also assume current prices are about right – or why we think the growth shares of a few years back are dirt cheap at PE ratios still well in excess of 20.

    In a 1998 study, Odean found share investors typically sell shares that will outperform in the future to buy shares that will give them lower returns.In other words, they sell winners to buy losers.Kahneman reckons this was partly due to overconfidence and partly due to seeing patterns where none existed. Suggested countermeasures: Avoid the tendency to talk long-term and act short-term.Remember that your brain can kid you that anything that happens a couple of times is a trend.

    If you have an appropriate strategy, stick to it. Kahneman says you should also ask yourself, before making a decision, whether there's a chance the reasons behind your planned trade might be random. List the reasons it's not before you commit.


    You've been framed

    As anyone who has watched Yes Minister would know, there are many ways of making judgements on a piece of information – depending on how it's presented.
    Perhaps our ancient ancestors didn't see the need for subterfuge, but we tend to process information in the context in which it is framed or presented.

    Let's say you've just received a $20,000 windfall.You are given two options: to receive another $5000 or a 50 per cent chance to win $10,000 and a 50 per cent chance of winning nothing.

    Now imagine a $30,000 windfall.Your options are: to lose $5000, or a 50 per cent chance of losing $10,000 versus a 50 per cent chance of losing nothing.

    Most of us feel the two situations are quite different – one is about making money, the other about losing it.We'll generally opt for the sure thing in the first question, but take the gamble in the second.

    Kahneman says most of us will also ignore the fact that we've suddenly become richer regardless of which option we choose.

    However, in rational terms, he says, both questions are identical because you're looking at definitely being $25,000 richer versus equal odds of being $20,000 or $30,000 richer.It's where you get to in the end, not the gains or losses along the way that should matter. Another example of framing is where you are offered a choice between cash or a fancy pen.Most will choose the cash.But extend that choice to cash, a fancy pen or a cheap pen and most will go for the fancy pen.It's an old sales trick to get buyers to commit by offering them an inferior option to the one they want to sell.

    Suggested countermeasures: Look at the same information from as many angles as possible and try to consider the big picture behind the facts.


    Fuzzy logic

    Investor psychology can be a frustrating science as there are apparent contradictions and no absolute or clear-cut answers.
    Basic investment disciplines, such as having a longterm strategy, researching decisions, buying and holding, and dollar-cost averaging, can all help to offset our natural tendency to act on poorly processed information.It's good news, too, that our brains are configured to learn from experience.Just a pity evolution doesn't work a bit quicker.

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