Mike Taylor: The psychology of making money

Investors like Warren Buffett have learned to understand what their emotions are telling them - file pic

If you've ever walked away from a property auction shaking your head in disbelief, you will know that emotions can get the better of investors.

As rational as we may be, greed and fear are a powerful force that can hijack even the best-laid plans - "I won't pay more than $800,000 for that house," you told your friend, but you find yourself putting your hand up for the 10th time to bid $895,000.

The first well-documented "speculative mania" took place in 1636-37 in Holland.
The Tulip Craze, as it is now known, saw the relatively conservative Protestant Dutch society bid up the price of tulip bulbs in a short time to eye-watering levels.

At the peak, some rare bulbs fetched as much at 5550 florins, which is more than $1 million in today's money. However, when the bubble burst, prices collapsed within months to their true value, leaving many in ruin.

Over the centuries, there are plenty of instances where emotions have disrupted normal functioning markets and irrational behaviour has taken over. For example, there have been banking panics, land and railroad booms, Wall Street crashes and the Tech bubble in the late 1990s.

At each instance, seemingly rational individuals have been affected by the herd mentality, and have bought and sold assets at prices that did not reflect fair value.

Often, investors justify their decisions by saying they are in a new paradigm and the current set of circumstances are set to continue forever. The reality is usually far from that - in fact, quite the opposite.

Considering that investor psychology plays such an important role in everyone's lives, there is very little research that has been completed on the subject - at least not much that has been widely distributed or is widely understood.

Most investment professionals would argue that greed and fear are the only two psychological factors that influence markets. However, this is a very narrow view as there are several other factors that play havoc with an investor's decision-making process.
Some common behaviour includes:

■Anchoring: This is a trait where an investor will "anchor" to a price that is important to them, but may have no relevance at all to the market they are investing in. For example, being focused on doubling your money, and only selling an asset if or when the price reaches this point.

■Loss aversion: Recognising a loss is uncomfortable for most people and investors will try to avoid it where possible. That means that if an asset is below the price the investor paid for it, they are prepared to wait in the hope they will get back to break-even. This can prove disastrous if the asset is in terminal decline. At best, it means your capital is stuck in a poorly performing asset when it could be reallocated elsewhere.

■Herd behaviour: From a young age, we learn to succumb to peer pressure as the path of least resistance. When it comes to investing, we take comfort if everyone else is doing the same thing. For example, if everyone is buying over-priced internet shares, even if your rational brain tells you this is madness, you justify your decision because, "all my friends are doing it and they are making money, so it must be OK".

Judging by the number of investors affected by emotional decisions, many would do well to spend time understanding their own investment weaknesses and learning how to make them work for them.

Just because an individual is vulnerable to making poor investment decisions, this does not mean they are doomed.

Some of the world's greatest investors, like Warren Buffet and George Soros, have learned to understand what their emotions are telling them and adjust their behaviour accordingly.

Investing intuition is an art, not a science, and having a good one means that you need to be an emotionally intelligent investor. Not only is it important to understand your own behaviour but it is also important to recognise these traits in others, and in the market.

Knowing what the other bidder at an auction may be feeling should play an important role in your investment strategy. Is the market exuberant? Have prices been declining or advancing?

Studying recent price action in the form of a chart is a way of gaining an understanding of price history of the asset you are buying. A chart will tell you a story of what has been going on in an asset or market and will give you a better gauge for sentiment.

Human emotions play a significant role in the movement of asset prices. Understanding the psychology of investing will help you make better decisions. Whether you are buying a house, shares or a classic car, it is always important have a feel for the market. To ignore your emotions will be to your peril.

Mike Taylor if the chief executive of PIE Funds