Beware the Bermuda Triangle of Investing

The dramatic fluctuations in the South African share market over the past quarter have undoubtedly unsettled many investors. Who isn't scratching their head at the fact that the market was down as much as 13% in August, and yet literally weeks thereafter the market reached a new all time record high.

From a financial planning perspective, these fluctuations are interesting to observe, but are very dangerous to act upon. Simply because we dont know what the market is going to be doing next week, next month, next quarter or even next year. If anyone tells you they know, they are lying.

So, if you shouldnt be worrying about the level of the share market, what should you be worrying about? There is much research to demonstrate that an investors own behaviour is the biggest obstacle to their investment success, and this should be of primary concern to investors. In an area of study called Behavioural Finance, much energy and resources is now devoted to studying investor behaviour, and from this work many insights about investors have emerged.
                                                                                    
At the heart of the constant challenge that investors face, is what can best be described as the Bermuda Triangle of Investor Behaviour. There are three core influences on investor behaviour, the three sides of this particular Triangle. Failure to heed these influences will undermine your financial plan, encourage inappropriate investment decision-making and raise the chances of your hard-earned savings disappearing into the Triangle. As we know, once something enters the Bermuda Triangle, it simply disappears.

Peer pressure

The three sides of the Triangle are, firstly, our responses to peer pressure; secondly, cognitive or mental mistakes we make; and thirdly, allowing our emotions to influence our decisions. These three elements can be a lethal cocktail of influence on investor behaviour and can undo the best-laid financial plans.

Peer pressure is at the heart of why investors demonstrate herding behaviour. Psychologists tell us that we adapt our behaviour to our circumstances or context, and as a consequence we are continually comparing ourselves to others. This is not necessarily a bad thing, but unfortunately we usually compare up rather than down.

For example, assume you were invested in a unit trust fund, and it was ranked as the 30th best performing unit trust. Research shows that you are more likely to compare your fund to the 29 funds that have outperformed it, rather than the over 700 funds that have underperformed it. Particularly if you know somebody who has a better performing fund! Unfortunately, our behaviour doesn't end at comparison, but very often we make decisions on this basis. The influence of social pressure is central to why we have bubbles in investment markets. People herd together for fear of missing out on a boom, or being caught out in a decline.

Mental mistakes

Cognitive or mental mistakes are very simply errors of judgment that we make, primarily because we are lazy when using our brains. A simple example of this when investing is that we tend to attach too much importance to recent performance and do not apply our minds to long-run statistics. This happens frequently in the share market, where it is much easier to say, the trend is your friend, than to consider what has happened over the long term historically.

What we do know is that over time the South African share market will deliver a real return to investors over about 7% above inflation. There is much historical data to support this observation. The problem is that at times, like last year, the share market delivered a real return of over 30%. This can raise unrealistic expectations about what the share market can deliver over time, and tempts us into action that may be inappropriate.

Emotional interference

The third side of the triangle is allowing our emotions to influence our investment decisions. Greed and fear are emotions we all experience. Few of us are immune to the allure of hitting the jackpot, or the fear of losing our money. As a consequence our emotions tempt us into believing that we can time our entry into, or exit out of, investment markets. Unfortunately the outcome of this belief is that there is much research to show that investors tend to buy when markets are near the top, and sell when markets are near the bottom. Our emotions lead us into the wealth-destroying behaviour of buying high and selling low.

An investment strategy is a critical part of your financial plan. If the strategy is based on sound, realistic objectives, then the strategy and your objectives should be the only reference point for your decision-making. Allowing your decisions to be influenced by social pressure; cognitive mistakes or your emotions will very likely derail what you are trying to achieve. Beware the Bermuda Triangle of investor behaviour, particularly when there is talk of a storm brewing.

By Robert Macdonald, Head: Xchange Solutions