The Commonsense Guide to Smart Investing

Published on Friday 2 January 2009 21:47

SHORT-term investment decisions are generally driven by greed or fear. That's why positive past performance figures can be so seductive, as the technology boom of the late 90s proved.

Prices soared under the weight of new money and the prevailing "feel-good factor" before, eventually, the bubble burst and shares fell sharply.

Many people joined the technology bandwagon late in the day, believing all the hype and not wanting to miss out. These investors got their fingers severely burned, but many still hold their technology or European growth fund today, in the forlorn hope that one day it may recover.

Similarly, perceived wisdom has argued that shares were high risk and poor value and that residential property and buy-to-let were secure assets with healthy prospects for future gains.

This happened in the late 80s and again from 2000 until a couple of years ago. In both instances, a property slump has followed the boom.

This is an in-built trait of all investment asset classes: they have periods where they perform well and periods where they perform badly.

The problem is that investors are keen to invest when there is a strong recent track record and they are keen to avoid after a period of poor performance.

The result is that a sizeable chunk of the investing population captures materially sub-market returns because of buying at the top of the market and then getting squeezed out at the bottom.

This has been evident again in recent months as the global economy has moved into a recession and investment assets, most notably equities, have registered significant losses and volatility.

A recent article in the New York Times accused investors of selling first and asking questions later, with fear ruling.

The same article quotes Professor Andrew Lo, who stressed that fear is more powerful than greed. He invokes a classic experiment, whereby participants are offered either 3,000 or an 80 per cent chance of 4,000. This is then reversed and the participants are asked whether they would rather have an 80 per cent chance of losing 4,000 or a certain loss of 3,000.

This is actually the same question, but not only do the participants give a different answer, they also give the mathematically incorrect, or irrational, answer to each. In other words, they would rather have the certain 3,000 on the upside, but would take the chance on the downside of the 4,000 loss, by gambling on the 20 per cent chance of no loss.

This example highlights how sentiment can impact on rational investment decisions. The shifting fortunes of equities over the past ten years have been well documented. Indeed the many so-called experts who a year ago were touting the prospects of "Brics" equities – those investing in Brazil, Russia, India and China – have gone strangely quiet.

However, other asset classes have similarly experienced periods of extreme popularity and negativity in recent times. Residential property, commercial property, commodities, hedge funds and even fixed interest funds, are all such examples.

The only way to avoid boom and bust cycles is to make objective decisions that ignore current investment fashions. It is crucial to take a long-term view of how different assets perform and to not be influenced by short-term performance, volatility or sentiment.

&#149 Graeme Lind is a wealth adviser at Towry Law in Edinburgh