Much like a sporting event or a film, the act of investing invokes emotion. Portfolio management can be dramatic; the ups and downs of the stock market, sudden losses of value, the elation when a fund has trebled in a day, the fury that accompanies a bad decision.
An investor's mind is a complex psychological terrain. This has given rise to a new science – behavioural finance.
An individual investor may be perfectly capable of managing money and taking a sophisticated approach to a portfolio. However, there is evidence that the same educated investor falls prey to decision biases that impact performance negatively.
While classical finance assumes that people are objective and can build rational portfolios to achieve the highest possible return, behavioural finance specialists have spotted a few major flaws in the argument.
They go on to suggest that decisions are affected by context, emotion and psychological biases that are unavoidable.
In trying to improve the process of decision-making, it is useful to understand the brain. There are two different decision systems in the brain.
The first is responsible for providing quick responses experienced at a more "intuitive" level. These intuitive responses are based on habitual behaviour and occur without much thought.
They originate from a more primitive part of the brain, responsible for serving our basic survival needs. A good example would be the reaction to a red versus green traffic light.
This mode has also been referred to as "heuristic" – that is, people make decisions based on approximate rules of thumb, rather than logic, or thinking about them.
The second decision system is far more "cognitive" because it requires a deeper analysis of all the information before arriving at a conclusion.
Not surprisingly, this is much harder work and the decision system resides in the cortex of the brain rather than at a more primitive subcortical level.
Most of our daily decision-making is based on "intuitive reasoning", requiring very little effort, reacting quickly to the information the brain provides.
A good illustration of the two systems would be the use of the 'numerical times table' – recalling from memory versus having to work out an answer by long multiplication.
However, things change under stressful conditions. In a stressful situation, the intuitive system could go wildly wrong, while the cognitive, logical system processes the information in exactly the same way as before, producing a more accurate response.
A stock market crash could induce a reaction that would be very different from the norm. Because it is more responsive, the intuitive system is susceptible to other powerful influences.
At a very fundamental level, human beings experience a degree of "field dependence", where the social setting provides cues to determine behaviour.
This is quite important for survival, as it assists in identifying the threats in the environment around us. In fact, 'social pressure' is one of the most powerful determinants of human behaviour, particularly in the highly networked social environments we all belong to, and when market panic occurs this causes a "herd instinct" in which individuals often abrogate their personal, autonomous rationality, further exacerbating the market effect.
Cognitive failures, as a result of stress or social pressure can result in a few problems – failure to see the big picture and examining decisions in isolation, using short-term decision horizons, buying low and selling high and the overconfidence bias where an investor trades too many times.
Losses are hard to deal with. In a portfolio of stocks, psychologically, losses outweigh gains, and there is a tendency to focus on the loss-makers. Even worse, an investor is more inclined to hold on to the loss-making stocks in the hope that luck will change.
Best described as an irrational attachment to an investment, specifically to a price, sector, or a piece of information that the investor holds dear. Quite often the investor has a significant 'portfolio experience' that alters his/her perception of a company or a sector.
Is the assumption that a recent set of events or a pattern of events will recur in the future. The recent financial meltdown is a classic example where a majority of the investment world believed that the downturn would repeat itself.
People tend to forget that safety in numbers is not safe at all because people in groups act on the basis of crowd behaviour, with emotion prevailing, rather than taking the risk of standing against the powerful effects of the group mind.
Decision-making is also limited by what Herbert A Simon called "bounded rationality".
This is where decision-making is limited by the information possessed, the cognitive limitations of people's minds, and the finite amount of time there is for decisions to be made.
The first step to avoid these psychological pitfalls is to become aware of and accept the way the mind works.
Educated investors are cautious and careful about succumbing to these common errors.
The next step is instilling a sense of discipline and self-control. Self-control strategies are – setting deadlines, using a cooling-off period before making a decision and setting firm rules.
Allen Zimbler is chief integration officer at Investec