The Psychology of Investing. Emotions affect people's behaviour and ultimately market prices.

The emotions surrounding investing are very real.  These emotions affect people's behaviour and ultimately, affect market prices.

Understanding the human dynamic (emotions) is so valuable in your own investing for these two reasons:

1. You will have guidelines to help you avoid the most common mistakes.
2. You will be able to recognise other people's mistakes in time to profit from them.

We are all vulnerable to individual errors of judgement, which can affect our personal success.

When a thousand or a million people make errors of judgement, the collective impact pushes the market in a destructive direction.

The temptation to follow the crowd can be so strong that accumulated bad judgement only compounds itself.

In this turbulent sea of irrational behaviour, the few who act rationally may well be the only survivors.

To be a successful focus investor:

• You need a certain kind of temperament.
• The road is always bumpy and knowing which is the right path to take is often counterintuitive.
• The stock market's constant gyrations can be unsettling to investors and make them act in irrational ways.
• You need to be on the lookout for these emotions and be prepared to act sensibly even when instincts may strongly call for the opposite behaviour.
• The future rewards focus investing significantly enough to warrant our strong effort.

Cinderella at the Ball. Warning investors about the "sedation of effortless money".

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.  Nothing sedates rationality like large dose of effortless money.  After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball.  They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice.  But they nevertheless hate to miss a single minute of what is one helluva party.  Therefore, the giddy participants all plan to leave just seconds before mid-night.  There's a problem, though:  They are dancing in a room in which the clocks have no hands. 


Warren Buffett's Cinderella parable in his 2000 shareholder letter.

Intelligence alone is not enough to ensure investment success.

The counterpart of emotion is rationality.

The size of the investor's brain is less important than the ability to detach the brain from the emotions.

"Rationality is essential when others are making decisions based on short-term greed or fear.  That's where the money is made," says Buffett.

Buffett tells us that successful investing does not require having a high IQ or taking the formal courses taught at most business schools.

What matters most is temperament.  And when Buffett talks about temperament he means rationality.

The cornerstone to rationality is the ability to see past the present and analyze several possible scenarios, eventually making a deliberate choice.  That, in a nutshell, is Warren Buffett.

Those  who know Buffett agree it is rationality that sets him apart from the rest.

Roger Lowenstein, the author of Buffett:  The Making of an American Capitalist, says, "Buffett's genius is largely a genius of character - of patience, discipline and rationality."

The Twelve Silliest (and Most Dangerous) Things People Say About Stock Prices

1.  If it's gone down this much already, it can't go much lower.

2.  You can always tell when a stock's hit bottom.

3.  If it's gone this high already, how can it possibly go higher?

4.  It's only $3 a share:  What can I lose?

5.  Eventually they always come back.

6.  It's always darkest before the dawn.

7.  When it rebounds to $10, I'll sell.

8.  What me worry?  Conservative stocks don't fluctuate much.

9.  It's taking too long for anything to ever happen.

10.  Look at all the money I've lost:  I didn't buy it.

11.  I missed that one, I'll catch the next one.

12.  The stock's gone up, so I must be right, or ... The stock's gone down so I must be wrong.


Reference:
One Up on Wall Street by Peter Lynch

Warren Buffett: The Fourth Law Of Motion

"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases."



Source: Letters to shareholders, 2005


Read more: http://www.businessinsider.com/warren-buffett-quotes-on-investing-2010-8?op=1#ixzz1oXDgcNy9

Efficient Market Hypothesis: Fact Or Fiction?

Published in Investing on 5 January 2012

Our economics series looks at the question of whether we really can beat the market.

How many times have you heard a would-be private investor saying something like: "You can't beat the game, because the big institutions always get the information ahead of you and get in first"?

If you believe that, you might be a proponent of the Efficient Market Hypothesis, which says that because the financial world is efficient in terms of information, it is impossible to consistently beat the market based on what you know when you choose where to put your money.

The idea was first developed by the economist Eugene Fama in the 1960s, following on from his observations that the day-to-day movements of the stock market resemble a random walk as much as anything else. And for a while, it came to be pretty much accepted as fact.

On the face of it, it does seem reasonable. Given that everyone has access to the same information, and there is a truly free price-setting equilibrium in which the balance of supply and demand is the determining factor in setting share prices (as it pretty much is with any free-traded commodity), surely the price will reflect all of the information available at the time, and you can't beat the market.

Fine in the short term

In the short term, the idea seems pretty much spot-on. New results are released and they look good, and you try to get in 'ahead of the market' to profit from them? Well, no matter how quick you are, it's too late and the price has already jumped. That's really no surprise, because the sellers of the shares have the same new information too, and the equilibrium point between supply and demand will instantly change.

But in the longer term, the Efficient Market Hypothesis is widely considered to be flawed. In fact, if you believed it held true over serious investing timescales, you probably wouldn't be reading this -- you'd have all your investing cash in a tracker fund and you'd be spending your spare time doing something else. (And that's actually not a bad idea at all, but it's perhaps something for another day).

There is plenty of empirical evidence that the market is what Paul Samuelson described as "micro-efficient" but "macro-inefficient", such that it holds true for individual prices over the short term but fails to explain longer-term whole-market movements.

Long term? Hmm!

And there are others, including the noted contrarian investor David Dreman, who argue that this "micro efficiency" is no efficiency at all, claiming instead that short-term response to news is not what investors should be interested in, but the longer-term picture for a company. It's pretty clear which side of that argument Foolish investors will come down on.

So why doesn't it work in the long run, and how is it possible to beat the market even in the presence of the ubiquity of news and an instantly adjusting price mechanism? Well, the major flaw is that the theory assumes that all participants in the market will act rationally, and that the price of a share will always reflect a truly objective assessment of its real value. Or at least that the balance of opinion at any one time will even out to provide an aggregate rational valuation.

It doesn't take a trained economist to realise what nonsense that can be. Any armchair observer who watched supposedly rational investors push internet shares up to insane valuations during the tech share boom around the year 2000 saw just how the madness of crowds can easily overcome calm rationality.

And the same is true of the recent credit crunch, when panicking investors climbed aboard the 'sell, sell, sell' bandwagon, pushing prices for many a good company down to seriously undervalued levels. What happens is that human emotion just about always outstrips rationality -- good things are seen as much better than they really are, and bad things much worse.

Irrational expectations

And it's not just these periods of insanity, either. There is, for example, strong evidence that shares with a low price-to-earnings ratio, low price-to-cash-flow ratio and so on, tend to outperform the market in the long run. And high-expectation growth shares are regularly afforded irrationally high valuations, and end up reverting to the norm and failing to outperform in the long term.

So what does that all say about the Efficient Market Hypothesis? Well, it certainly contributes to understanding how markets work, but we also need to include emotion, cognitive bias, short-term horizons and all sorts of other human failings in the overall equation.

And that means we can beat the market average in the long term, if we stick to objective valuation measures, don't let short-term excitements and panics sway us, and rein in our usual human over-optimism and over-pessimism.

http://www.fool.co.uk/news/investing/2012/01/05/efficient-market-hypothesis-fact-or-fiction.aspx

I don't understand why business schools don't teach the Warren Buffett model of investing.

I don't understand why business schools don't teach the Warren Buffett model of investing.


Or the Ben Graham model. Or the Peter Lynch model. Or the Martin Whitman model. (I could go on.) In English, you study great writers; in physics and biology, you study great scientists; in philosophy and math, you study great thinkers; but in most business school investment classes, you study modern finance theory, which is grounded in one basic premise--that markets are efficient because investors are always rational. It's just one point of view. A good English professor couldn't get away with teaching Melville as the backbone of English literature. How is it that business schools get away with teaching modern finance theory as the backbone of investing? Especially given that it's only a theory that, as far as I know, hasn't made many investors particularly rich.

Meanwhile, Berkshire Hathaway, under the stewardship of Buffett and vice chairman Charlie Munger, has made thousands of people rich over the past 30-odd years. And it has done so with integrity and a system of principles that is every bit as rigorous, if not more so, as anything modern finance theory can dish up.

On Monday, 11,000 Berkshire shareholders showed up at Aksarben Stadium in Omaha to hear Buffett and Munger talk about this set of principles. Together these principles form a model for investing to which any well-informed business-school student should be exposed--if not for the sake of the principles themselves, then at least to generate the kind of healthy debate that's common in other academic fields.

Whereas modern finance theory is built around the price behavior of stocks, the Buffett model is centered around buying businesses as if one were going to operate them. It's like the process of buying a house. You wouldn't buy a house on a tip from a friend or sight unseen from a description in a newspaper. And you surely wouldn't consider the volatility of the house's price in your consideration of risk. Indeed, regularly updated price quotes aren't available in the real estate market, because property doesn't trade the way common stocks do. Instead, you'd study the fundamentals--the neighborhood, comparable home sales, the condition of the house, and how much you think you could rent it for--to get an idea of its intrinsic value.

The same basic idea applies to buying a business that you'd operate yourself or to being a passive investor in the common stock of a company. Who cares about the price history of the stock? What bearing does it have on how the company conducts business? What's important is whether you can purchase at a reasonable price a business that generates good returns on capital (Buffett likes returns on equity in the neighborhood of 15% or better) without a lot of debt (which makes returns on capital less dependable). In the best of all worlds, the company will have a competitive advantage that allows it to sustain its above-average ROE for years, so you can hang on to it for a long time--just as you would live in your house--and reap the power of compounding.

Buffett further advocates investing in businesses that are easy to understand--Munger calls it "clearing one-foot hurdles"--so you can come up with more reliable estimates of their long-term economics. Coca-Cola's basic business is pretty staid, for example. Unit case sales and ROE determine the company's future earnings. Companies like Microsoftand Intel--good as they are--require clearing much higher hurdles of understanding because their business models are so dependent on the rapidly evolving world of high tech. Today it's a matter of selling the most word-processing programs; tomorrow it's the Internet presence; after that, who knows. For Coke, the challenge is always to sell more cases of beverage.

Buying a business or a stock just because it's cheap is a surefire way to lose money, according to the Buffett model. You get what you pay for. But if you're evaluating investments as businesses to begin with, you probably wouldn't make this mistake, because you'd recognize that a good business is worth buying at a fair price.

Finally, if you follow the Buffett model, you don't trade your investments just because our liquid stock markets invite you to do so. Activity for the sake of activity begets high transaction costs, high tax bills, and poor investment decisions ("if I make a mistake I can sell it in a minute"). Less is more.

I'm not trying to pick a fight with modern finance theory enthusiasts. I just find it unsettling that basic business-school curricula don't even consider models other than modern finance theory, even though those models are in the marketplace proving themselves every day.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/teachbuffet.htm

Lessons from the '87 Crash

SPECIAL REPORT October 11, 2007

Lessons from the '87 Crash

Enjoying the Dow's record run? Don't get too comfy. The market's Black Monday breakdown is a reminder of how quickly investor sentiment can turn

by Ben Steverman

As major stock indexes hit all-time highs, it's worth looking back 20 years to a far gloomier time, when investors were cruelly and suddenly reminded that the value of their investments can depend on something as unpredictable as a mood swing.

Every once in a while, fear, snowballing into panic, sweeps financial markets—the stock market crash of October, 1987, now celebrating its 20th birthday, is a prime example.

In the five trading sessions from Oct. 13 to Oct. 19, 1987, the Dow Jones industrial average lost a third of its value and about $1 trillion of U.S. stock market value was wiped out. The losses culminated in a panic-stricken 22.6% decline in the Dow on Black Monday, Oct. 19. The traumatic drop raised recession fears and had some preparing for another Great Depression.

Stock market crashes were nothing new in 1987, but previous financial crises—in 1929, for example—often reflected fundamental problems in the U.S. economy.

MYSTERIOUS MELTDOWN
The market's nervous breakdown in 1987 is much harder to explain. Especially in light of what came next: After a couple months of gyrations, the markets started bouncing back. The broad Standard & Poor's 500-stock index ended 1987 with a modest 2.59% gain. And in less than two years, stocks had returned to their pre-crash, summer of 1987 heights.

More importantly for most Americans, the U.S. economy kept humming along. Corporate profits barely flinched.

To this day, no one really knows for sure why the markets chose Oct. 19 to crash. Finance Professor Paolo Pasquariello of the University of Michigan's Ross School of Business says the mystery behind 1987 prompted scholars to come up with new ways of studying financial crises. Instead of just focusing on economic fundamentals, they put more attention on the "market microstructure," the ways people trade and the process by which the market forms asset prices.

True, in hindsight there are plenty of adequate reasons for the '87 crash. Stocks had soared through much of 1987, hitting perhaps unsustainable levels: In historical terms, stock prices were way ahead of corporate profits. New trading technology and unproven investing strategies put strain on the market. There were worries about the economic impact of tensions in the Persian Gulf and bills being considered in Congress.

OUT OF SORTS
But for whatever reason, the mood on Wall Street shifted suddenly, and everyone tried to sell stocks at once. "Something just clicked," says Chris Lamoureux, finance professor at the University of Arizona. "It would be like a whole crowded theater trying to get out of one exit door."

It's a fairly common phenomenon on financial markets. Every stock transaction needs a buyer or a seller. When news or a mood shift causes a shortage of either buyers or sellers in the market, stock prices can surge or plunge quickly. Most of the time, balance is quickly restored. Lower prices draw in new buyers looking for a bargain, for example.

Sometimes, as in 1987 and many other true crises, things get out of hand. What happens at these moments is a mystery that may be best explained by dynamics deep within human nature.

Usually, explains behavioral finance expert Hersh Shefrin, a professor at Santa Clara University, investors believe they understand the world. In a crisis, "something dramatically different happens and we lose our confidence," Shefrin says. "Panic is basically a loss of self-control. Fear takes over."

BUYERS AND SELLERS
Why don't smart investors, seeing others panic and sell stocks, step in to buy them up at a bargain?

First, it's very hard, in the midst of a crisis, to tell whether markets are acting rationally or irrationally. Buyers refused to enter credit markets this summer on fears about risky mortgage debt. It will take months, maybe years, to add up the full impact of losses on subprime loans.

It's also tough to think rationally yourself. "It's hard to keep your emotions in check when your money is on the line," Shefrin says.

And, even if you're confident the panicked market is giving you a buying opportunity, you're likely to want to wait until it hits bottom. If a market is in free fall, buying stocks on the way down is likely to give you instant losses.

Not only will buyers hold back. A falling market will bring many more sellers out of the woodwork. Leverage is one reason: Many investors buy stocks on borrowed money, so they can't afford to lose as much without facing bankruptcy.

This is one explanation for the temporary, sharp drops in many financial markets in the summer of 2007. Losses on leveraged mortgage debt prompted many hedge funds to dump all sorts of assets to raise cash.

THERAPY FOR A PANICKED MARKET
The solution to a panicked market, many say, is slowing down the herd of frightened investors all running in the same direction. New stock market rules instituted since 1987 pause trading after big losses. For example, U.S. securities markets institute trading halts when stock losses reach 10% in any trading session. "If you give people enough time, maybe they will figure out nothing fundamental is going on," University of Michigan's Pasquariello says.

There's another form of therapy for overly emotional markets: information. In 1929 and during other early financial crises, there were no computer systems, economic data were scarce, and corporate financial reporting was suspect. "The only thing people knew in the 1920s was there was a panic and everybody was selling," says Reena Aggarwal, finance professor at Georgetown University. "There was far less information available." In 1987, and even more today, investors had places to get more solid data on the market and the economy, giving them more courage not to follow the herd. That's one reason markets found it so easy to shrug off the effects of 1987, Aggarwal adds.

You can slow markets down, reform trading rules, and tap into extra information, but financial panics may never go away. It seems to be part of our collective human nature to occasionally reassess a situation, panic, and then all act at once.

Many see the markets as a precarious balance between fear and greed. Or, alternatively, irrational exuberance and unwarranted pessimism. "All you need is a shift in mass that's just big enough to push you toward the tipping point," Shefrin says.

IN FOR THE LONG HAUL
What should an individual investor do in the event of a financial crisis? If you're really sure that something fundamental has changed and the economy is heading toward recession or even another depression, it's probably in your interest to sell. But most experts advise waiting and doing nothing. "In volatile times, it is very likely that you [will be] the goat that other people are taking advantage of," University of Arizona's Lamoureux says. "It's often a very dangerous time to be trading."

Shefrin adds: "The chances of you doing the right thing are low." Don't think short-term, he says, and remind yourself of the long-term averages. For example, in any given year, stock markets have a two in three chance of moving higher. Other than that, it's nearly impossible to predict the future.

So, another financial panic may be inevitable. But relax: There's probably nothing you can do about it anyway. Anything you do might make your situation worse. So the best advice may be to send flowers to your stressed-out stockbroker, stick with your long-term investment strategy, and sit back and watch the market's roller-coaster ride.

Steverman is a reporter for BusinessWeek's Investing channel .

http://www.businessweek.com/investing/content/oct2007/pi20071011_494930.htm

Market Behaviour: Control Yourself (Patience)

Patience is a virtue you must learn in order to excel as a value investor.  You must think outside the box and move in a direction the crowd likely is not following.

If you want to invest intelligently according to the basics established by value investing master guru Benjamin Graham, you must control the following:

1. Your brokerage costs
2. Your ownership costs
3. Your expectations
4. Your risk
5. Your tax bills
6. Your own behaviour

----

1.  Your Brokerage Costs

Find yourself a good broker who doesn't charge too much to handle your stock trades.  If you feel confident that you know how to handle stock trading, do it yourself with an Internet discount broker.

We don't recommend full-service brokers because you don't need their research services and you certainly won't want to follow their advice - unless by some lucky break you find a broker who truly believes in value investing.

Also, don't trade too often and waste your money jumping in and out of stocks.  Most value investing gurus hold on to stocks for four to five years.

Learn to be patient and give a stock you've picked time to recover.  Its price may go down after you buy the stock, so don't get discouraged.  Few people can actually buy at the absolute lowest price.  Most value investors choose a stock on its way down.

But don't be so patient that you end up losing all your money.  Sometimes, you will make a mistake when picking a stock.  Just admit your mistake, accept your losses and move on.

2.  Your Ownership Costs

If you decide to invest using mutual funds, be sure to buy no-load funds with very low management fees.  Few funds are worth the cost if their management fees are more than 1 percent.

Remember, for a mutual fund manager to meet the returns of a stock market index, he or she must beat the index by at least the cost of the mutual fund's management fees.  Management fees are a drain on all mutual funds.  

Unless for some reason you've picked a particular mutual fund manager you want to follow, your best bet is to invest using an index fund.  Fees for many index funds are just 0.15 to 0.35 percent.

3.  Your Expectations

Always be realistic about the returns you want to get out of a stock purchase.  Even if you decide to follow some newsletters that specialise in value investing, don't get caught up in someone else's hype.  You'll never be disappointed if you carefully assess the true value of a stock and are conservative about the cash flows you can expect from the stock purchase.

4.  Your Risk.

Keep a close eye on the amount of risk you can tolerate.  Determine the asset allocation that best manages your risk tolerance.  

Periodically re-balance your portfolio so you know that you're maintaining your portfolio at a risk tolerance level that you can tolerate.

Determine how much of your portfolio you can afford to put at risk.  Stock investing is a risky business.  You can afford to take more risk if you have a longer time frame before you need the money.  

For example, if you won't need the money for 10 years or more, you can take on the greatest amount of risk. If you plan to use the money in two years, put that money in a cash account.

5.  Your Tax Bills

Each time you sell a stock, you may have to pay taxes on the amount of profit you make from the transaction. If you hold a stock for less than 12 months, the taxes you pay are based on your current tax rate.  

If you hold a stock for more than 12 months, your tax bill could be as little as 5 percent for capital gains, if you are in the 10 percent or 15 percent tax brackets.  You'll pay 15 percent capital gains tax if your tax bracket is 25 percent or higher.

Unless you've made a terrible mistake picking a stock, you should always hold it for more than a year, to minimize the tax hit on any gain.  The only exception to this rule is fi you have a significant profit in a stock and you're afraid the stock could take a tumble.

6.  Your Own Behaviour

It's human nature to get excited and follow the crowd in feeling good about a stock.  The crowd shows its enthusiasm when it bids the price up so high that the P/E ratio tops 20.  Learn to resist these feelings.

It;s also human nature to get frightened when everyone is running from the stock market.  Get your emotions under control and start to take a look for good buys when everyone else thinks it's time to escape.

Related topics:

Market Behaviour: The Least You Need to Know
Market Behaviour: Crowd Impacts on Stock Prices

Market Behaviour: Can You Beat the Market?
Market Behaviour: Bull Runs
Market Behaviour: Bear Stalls
Market Behaviour: Pendulum Swings (Volatility)
Market Behaviour: Irrational Exuberance
Market Behaviour: Unjustifiable Pessimism
Market Behaviour: Control Yourself (Patience)

Market Behaviour: Can You Beat the Market?

The best answer to this question is, sometimes - but don't count on it.

Generally, the market does a pretty good job of pricing stocks, but when the crowd is acting irrationally, you can find your best and worst buys.

Don't try to beat the market.  

Instead, focus on building the best portfolio you can.  

Buy stocks when they're cheap and sell them when they recover.  

Do not worry about missing the highest highs because you rarely can sell at just the right time to avoid the steep drop-off when the price of a stock plummets.

MOST PEOPLE GET CAUGHT UP IN THE EMOTIONAL HIGHS THEY FEEL AS STOCKS CLIMB AND DON'T ACT TO TAKE PROFITS BEFORE IT'S TOO LATE.  DON'T GET CAUGHT UP IN THAT TYPE OF BEHAVIOUR.

Related topics:

Market Behaviour: The Least You Need to Know
Market Behaviour: Crowd Impacts on Stock Prices

Market Behaviour: Can You Beat the Market?
Market Behaviour: Bull Runs
Market Behaviour: Bear Stalls
Market Behaviour: Pendulum Swings (Volatility)
Market Behaviour: Irrational Exuberance
Market Behaviour: Unjustifiable Pessimism
Market Behaviour: Control Yourself (Patience)

Behavioural Finance: Irrational Behaviour and Stock Market Investing

"You have great skill with your bow, but little control of your mind", said the master to his young archer.

This is also applicable in investing.  You can know everything about valuing companies, but it'll come to nothing if you can't apply it rationally when the heat is on.

Human behaviour is directed by a combination of evolutionary hardwiring and development programming, and you can see both in everything we do.

The trouble is that in stock market investing, a very recent phenomenon in human evolution, we haven't developed behaviours appropriate to it.

The usual range of other behaviour responses that we picked up in our early life are often completely inappropriate.

The greatest enemy in investing is actually yourself.  Beware of your irrational and yet human behaviour jeorpadising your investing.

Insights into Irrational Minds and Markets

http://www.centaur.co.za/investment_methodology/index.html

Curb irrational behaviour: Be aware of ANCHORING, a common mind trap when investing.

Curb irrational behaviour

Annette Sampson
April 7, 2010

The strategy To avoid common mind traps when investing.

You're talking about fear and greed, right? There's no doubt fear and greed are behind a lot of investor behaviour - much of it is irrational. But a school of study, known as "behavioural finance", has demonstrated our minds are hard-wired to react in certain ways. Even if we make concerted efforts to avoid fear and greed, our thought patterns may lead us to make investment decisions that could prove costly.


Such as? There are many aspects to behavioural finance but one area Tyndall Investment Management's Australian equities team believes may be influencing investor behaviour at the moment is "anchoring".  In simple terms, this is the tendency we have to base our judgment on a piece of initial information then stick with it even if other information becomes available.

To show how it works, Tyndall looked at research by two behavioural finance experts, Amos Tversky and Daniel Kahneman. They asked two groups of people what percentage of the United Nations comprised African countries. 

• The first group was asked whether it was above or below 10 per cent; 
• the second whether it was above or below 65 per cent. 

The numbers were supposedly chosen randomly (the groups didn't know the "random" spin of the wheel was rigged) but it still influenced their estimates.

• The first group, having a lower "random" figure estimated an average 25 per cent of African countries; 
• the second 45 per cent.

In the absence of real information, the test groups tended to "anchor" their estimates on any information available rather than thinking independently.

In another study, psychologist Ward Edwards asked people to imagine 100 bags of poker chips. Each bag contained 1000 chips but 45 contained 700 black chips and 300 red while 55 contained 300 black and 700 red.

• When asked what the probability was of selecting a bag with mostly black chips, most of the test subjects got it right. 
• The answer was 45 per cent.

But he then asked them to imagine 12 chips were randomly selected from the bag - eight black and four red. The chips were put back and the respondents were asked whether they would change their first answer in response to the new information.

• Many said the probability of the bag containing mostly black chips was unchanged at 45 per cent. 
• Most said the likelihood was less than 75 per cent. 
• But calculated mathematically, the bag was 96.04 per cent likely to contain mostly black chips. 
• The respondents didn't take account of the new information.

But how does that relate to my reactions to investment markets? Tyndall says the same research has been conducted on analysts' reactions to company earnings announcements.

• They often don't revise their estimates enough when they receive new information, resulting in a string of earnings "surprises". 
• It says the recent rally has resulted in largely favourable earnings forecasts but if the numbers don't live up to expectations and investors haven't factored in changing circumstances to their thinking, the market could fall sharply.

It says basing future investment performance on past returns is another common example of anchoring.

• After shares fell more than 38 per cent in 2008, most investors expected a dud 2009. 
• Certainly no one was predicting a rise of 37 per cent. Investors who switched money out of shares paid dearly.

So how do I avoid this trap?

• Understanding these behaviours and being aware of them can help you make more informed and rational decisions. 
• Even better, Tyndall says, it can give you an edge, allowing you to identify, and make money from, mispricing opportunities that come about because of other people's irrational behaviour.

Old favourites, such as having a diversified portfolio, getting good professional help and looking to the long term can help.

http://www.smh.com.au/news/business/money/investment/curb-irrational-behaviour/2010/04/06/1270374188426.html?page=fullpage#contentSwap1