This article was published on 9 September 2006. Some information may be out of date.

Excerpt from Get Rich Slow

This week, and through September, we are running excerpts from Mary Holm’s bestselling book, “Get Rich Slow: How to grow your wealth the safe and savvy way.” Mary’s regular Q&A column will resume in October.

HOW OUR EMOTIONS AFFECT OUR 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:

  1. Over-confidence

    About 80% 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.

  2. 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.

  3. 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.

  4. 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!

  5. 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.

  6. 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 ten years than over the last three months.

  7. Seeing patterns

    It’s often useful to see patterns in data. Sometimes, though, people see patterns that are there by mere coincidence. Around the time of the 1929 Wall Street Crash, for example, observers noted a close correlation between New York and London share prices and levels of solar radiation.

  8. 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.

  9. Selective listening

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

  10. 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.

THE ROLL OF COINS

Delegates at a conference were given a roll of five-cent coins. They were told they could either pay five cents every time they entered the conference room, or give up the whole roll and receive a pass that let them come and go as they pleased.

Almost everyone handed in the roll up front — even though the alternative would have cost them only about half as much, says a report in Financial Alert magazine. The conclusion: Most people want to minimise risk. They may pay quite a high price for comfort and certainty.

But is this correct? Would the results have been the same with $2 coins? Some people probably couldn’t be bothered paying on each entry for the sake of gaining a few 5 cent pieces!

YOUR RESPONSE TO RISK

Try this quick quiz:

  1. Would you prefer me to give you:
  1. $1,000 or
  2. $2,000 or zero, depending on a toss of a coin?
  1. Would you prefer me to take from you:
  1. $1,000 or
  2. $2,000 or zero, depending on a toss of a coin?

There are no correct answers. But if you were behaving rationally, you would always choose (a). The two options have the same average expected return, of $1,000, but (b) is riskier. According to rational theory, nobody will take more risk unless they expect more reward.

However, finance strategist Jack Gray says about a third of people choose (b) for question 1. When they see themselves getting something for nothing, they like to take a risk. Even more interestingly, about two-thirds choose (b) for question 2. Many people are prepared to take a risk to try to avoid a loss.

Apparently, people feel more negatively about loss than they feel positively about gain.

Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to [email protected] or click here. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.