Our brains evolved in an environment where day-to-day survival was paramount. We therefore tend to lack perspective when faced with the rich and complex world of the 21st century, and in particular, we seem to struggle with making good decisions when it comes to the stock market.

One problem is that when faced with a situation of uncertainty, our decision making is strongly influenced by mental shortcuts. Anchoring, the tendency to latch on to an initial piece of data against which we then judge all future information is a key example. When we invest, we may become anchored to the current prices of assets and thus vulnerable to misjudgments about the future.

Anchoring compounds mistakes

Anchoring also compounds other mental mistakes such as the tendency to be overconfident. In a rising share market, for example, investors tend to assume that current stock prices are roughly fair value and each new market high becomes an anchor against which subsequent highs are judged.

Anchoring works in other ways too, for example, when a company that has delivered poor performance in recent years announces some startlingly good news with a potentially large increase in earnings, most of us would probably under react. The price anchor is so low that, instead of completely reassessing the company’s outlook, we are more inclined to consider the news in relation to our previous (negative) view of it.

The stock price anchor will tend to rise in increments as good news sinks in, hence the reason why equity research analysts usually raise their company earnings’ forecasts in small shifts. In these circumstances, competent fund managers and investors may be ahead of the market in identifying genuinely good news.

Anchoring is worsened by the propensity to be excessively confident

Anchoring is worsened by the propensity for investors to be excessively confident of their abilities, particularly if they have enjoyed recent success. This may contribute to their tendency to try to DIY without the necessary skills and experience, make decisions too rapidly without sufficient analysis, fail to diversify portfolios sufficiently or trade investments too frequently.

Research shows that investors who had recently done well from investing in shares, moved their activities online, traded stocks more frequently, speculated more and achieved lower returns. In theory, trading through the internet should lower costs and lead to faster processing. But the biggest problem of investing through the Internet is that it leads investors to trade too often as it enables them to act too easily on overconfidence.

Some other common mental traps include:

• Hyperbolic time discounting — substantially discounting the value of future benefits compared to benefits today. Evolutionarily, there was little advantage to looking too far ahead and our modern culture reinforces an orientation towards instant gratification.

• Myopic loss-aversion — the suffering of more pain from the loss of a Rand than from an equivalent gain. When people invest in the share market for the long term but measure their performance over short term, the result is a spectacular failure to stay the course and a missing out on the equity risk premium.

• Herding — this behaviour provided such a strong evolutionary advantage in the savannah that it is massively ingrained in us, even though in the modern world it can produce highly destructive outcomes when used inappropriately.

Tips for being prepared:

• Research companies or funds and have a good knowledge of their fundamentals. Do your research in areas that interest you and that you have some knowledge about and in areas where you’re likely to do a better job.

• Have the confidence and discipline to act when the opportunity arises. Don’t get caught up in the herd and don’t be too greedy.

• Make investment decisions within an overall plan and seek professional advice. Do your research on good financial planners. This will assist with issues of overconfidence and anchoring.

Warren Buffett, the world’s most successful investor, uses three main techniques to overcome behavioural limitations:

• Reframing the way the market works and considering volatility as a friend which provides opportunities.

• Undertaking rigorous analysis on companies within his circle of competencies, before making decisions. This provides confidence and mental fortitude to see the fluctuations in markets as good rather than bad.

• Having reasonable expectations of performance, remaining patient and avoiding the distractions of greed and peer pressure. This resilience is drawn from an array of disciplines including philosophy, psychology, economics and finance theory.

From ‘How Much is Enough?’ by Arun Abey and Andrew Ford.