Sometimes investor behaviour, rather than market performance, dictates returns. In the early half of the year the equity market experienced sharp price corrections. But instead of seeing this as a buying opportunity, investors withdrew a net R6.7-billion from equity and real estate unit trusts while R9-billion flowed into money market unit trusts. Only hindsight will reveal whether this behaviour was beneficial or not. But it does illustrate the typical response to falling prices.

Traditional financial theory assumes that investors behave rationally when making investment decisions, but human behaviour tends not to follow this directive. Emotions affect the financial and investment decisions made every day.

Studies have shown that investors are particularly bad at picking the right times to buy or sell investments. Even professional and institutional investors find that selling shares that are rising in price while buying those that are falling is rational, but difficult to implement. Investors are usually more comfortable buying shares when prices are high and rising, and selling when prices are low and falling.

"It’s wise to remember that share prices are often driven high above their intrinsic value before crashing under their own weight," says Johan de Lange, director of Allan Gray Investor Services.

Sometimes it takes a turbulent period of sharp increases and declines before the markets re-establish their connection to economic and commercial fundamentals. The same is also true on the downside.

Disinvesting locks in losses

"One of the worst things you can do when the market falls is to take your money out of the market. This short-term strategy locks in losses and erases any hope of future gains," he says.

Human strategies for handling risk and reward helped our ancestors survive on the hunting plains, but aren’t appropriate to our modern-day financial lives.

In evolutionary terms, it’s an advantage to be able to adapt to changes in the environment — and quickly. But this can create knee-jerk reactions to changes in the financial markets and make you fall into the trap of extrapolating recent asset price movements into the future, even when this is illogical.

"Prices are inherently ambiguous yet we focus on the most recent price information and ignore longer-term input," says de Lange.

In the jungle, it’s a good defence against predators to run when you see the rest of the pack running. Those who stopped to ask questions probably didn’t survive so their genes feature less prominently in the modern human than those who instinctively ran with the herd.

Attractive investment opportunities arise from going against the fearful, greedy crowd

In the financial markets, however, it’s much more rewarding to stop and think than to instinctively do what others are doing, because attractive investment opportunities arise from going against the fearful, greedy crowd. This is the source of many bargains.

De Lange says that because of our human foibles, the prices of shares and other securities go through periods of irrational gain and loss that are not related to the fortunes and prospects of the underlying business.

Share prices are nothing more than the aggregate of investor sentiment at any point in time, the true value of the underlying business is the present value of all future dividends. Share prices are far more volatile than this intrinsic value for all of the reasons listed above. Therefore there are times when shares can be bought for less than they’re rationally worth to a long term investor. The more irrational the price movements, the greater the opportunities, de Lange says.

In conclusion de Lange says it’s particularly important to maintain discipline in the current turbulent markets and not be diverted from the basics of investing. "Have an investment objective, stick to it and always take a long term view."