Two types of people: rational ones and investors

Goodinvesting assumes people have a high degree of rationality and emotional detachment. However, investors often make wealth-related decisions based on highly reactive,emotive and impulsive factors rather than a clear, long-term plan backed by solid, objective information.

When equity markets reached then record lows in July 2002, net outflows from US equity mutual funds (unit trusts) were their largest in 18 years. In other words, investors panicked and sold at, or near, the bottom of the market.

Emotion and impulsiveness are negative psychological ‘habits’ that impede rational analysis and prevent investors from maximising their investment potential.

Investors are often prone to herding behaviour and so are often reluctant to make decisions that, while believed to be correct, go against popular sentiment. And when made, these decisions may be based purely on short-term market fluctuations. This is also known as ‘myopic loss aversion’. Investors may then perceive stocks to be riskier than they are and hence give less weight to important longer-term trends.

Given that over long periods the probability of equity losses are greatly reduced, investors influenced by loss aversion would be more likely to hold shares if they monitored them less frequently. The true time horizon for the average investor is 20 to 30 years, with results in between merely representing paper gains or losses. Advisers can help their clients understand the importance of adopting a long-term holding period for their investments.

An interesting aspect of loss aversion is a phenomenon called ‘anchoring’ whereby investors often assume current stock prices are ‘about right’, paying more attention to recent experience and less attention to long term averages.

The result is that investors become overly optimistic in rising markets and overly pessimistic in falling ones. They may then sell out at the low point in the investment cycle and miss critical opportunities to buy when prices are attractive.

In helping their clients to invest well, financial advisers are able to blend positive investment psychology with sound practical advice.

Firstly, investors should have a clear understanding of their own financial goals and should take the time to understand how investment markets behave. Advisers can encourage investors to pre-commit to a personal investment plan (using a tailored asset allocation strategy and sticking to it) to achieve a better focus and perspective on their investment portfolio.

Secondly, advisers can encourage the development of a partnership with the client in order to maximise good investment habits.

Thirdly, advisers can help their clients more effectively manage their investment expectations. The reality is that most people recognise they will need at least $30,000 per year in retirement, yet few people have made adequate provision to receive this level of income.

Ultimately, the role of the financial planner will continue to be critical for investors, irrespective of recent publicity.

Gordon Thoms is head ofadviser distribution,JBWere Investment Management