Mary Holm: How our emotions affect investing

Feelings affect most things you do. And quite right, too! Should you let them affect your investment decisions? To some extent, yes. It's important to feel comfortable about your savings. And, if you have a positive attitude, you're likely to save more.

But a growing body of research shows that emotions, prejudices, limited vision and other psychological factors affect investing in ways you may not be aware of. This can lead to decisions that hurt your chances of getting the best risk-adjusted returns you can. It's helpful - as well as fascinating - to be aware of what's going on. You may then modify your behaviour or at least make allowances for it. Some common investor foibles:

Over-confidence
About 80 per cent of people think they are above average at driving, and investing may be similar. People tend to remember their good investments and give themselves credit for them. The poor investments were bad luck, best forgotten!

Over-confidence can lead to too little diversification. If you've picked good investments, why hedge your bets? The answer is that your selections might, in fact, not be so hot. Also, when inexperienced investors start an investment, they often don't appreciate that they will sometimes do badly. At different times, both share and property investors have suffered from such delusions. Time always teaches them the error of their thinking.

Fear of regret
Many investors don't want to sell unless they can get more than the purchase price - and sometimes end up sticking with a "dog" for years. Even professional managers tend to hold their losers for too long and sell their winners too quickly, research shows.

I'm not saying you should bail out of well chosen investments just because they have bad years. But if you realise an investment is wrong for you, get out of it. It's irrelevant what you paid for it.

Following the crowd
You may feel it's not so bad to make a loss if everyone else does. It may be less embarrassing, but there's no logic to that. You're more likely to do well if you buy when others are selling and sell when others are buying. Or, in many cases, it's best to just buy and hold.

Sticking with the status quo
If you were starting now, would you have your current portfolio? If not, why have you got it?

Many people spend more time deciding which clothes to buy than which investments to make. Put a bit of time into your investments now - assessing what you have and making a long-term plan to strengthen your position - and you'll be able to buy many more clothes later!

Being over-informed
Having lots of information makes some investors over-confident. But others are overwhelmed. After doing research, they can't decide which move to make and so do nothing. If you've narrowed your options down to two or three, perhaps you should just allocate your money among them rather than agonising over which might be best.

Short sightedness
People put too much weight on the recent past. After a bad market, they overestimate the chances of another bad year. The reverse is true after a good market.

Economist Richard Thaler once suggested investors should be banned from reviewing their progress more than once every five years. But many investors receive quarterly statements, and some check their progress daily. It's far better to put more weight on how you've done over the last five or 10 years than over the past three months.

Seeing patterns
It's often useful to see patterns in data. Sometimes, though, people see patterns in coincidence. Around the 1929 Wall Street crash, for example, observers noted a close correlation between New York and London share prices and levels of solar radiation.

The frame-up
People respond to how things are framed. They don't like an investment that has losses one year in 10 as much as one that has gains nine years in 10!

Another example: Given a choice of a share fund and a bond fund in a super scheme, investors tend to put half their money in each. But given a choice of a fund of big NZ shares, a fund of small NZ shares, a world share fund and a bond fund, they will tend to put a quarter in each, ending up with much more in shares.

Selective listening
Most people like to have their pre-judgements confirmed. If, instead, you challenge your thinking, you would learn more.

Can't see the forest
Investors tend to look at the performance of individual parts of their portfolio instead of the whole thing. If you've diversified to smooth out the movements of different investments, let that work for you.