Managing your money behaviour, and avoiding common behavioural traps, can help you put the right foot forward when it comes to long-term success with money.

Why do mature women make better investment decisions than young men? Why does trading shares online bring worse results than the old fashioned way? Why do we all think we’re better-than-average with money (and other areas of life)? And what can we do about it?

An emerging area of research called behavioural finance – which looks at the way we behave with money and investments – is shedding light on questions like these. And the results are fascinating. How we think about and manage our money has a huge impact on our lives – especially in the current environment. The good news is there are effective strategies to help us keep perspective, whatever happens in markets.

If it looks too good to be true…

One of our better human traits is that we’re basically optimistic. But this also makes us vulnerable to ‘too good to be true’ marketing offers. As a society we spend twice as much on mass marketing than on education. So it’s little wonder we’re influenced so strongly by our environment and the promises of a consumer culture.

One of the only benefits of the global financial meltdown is that operators of dodgy investment schemes and ‘too good to be true’ offers have been put out to pasture. Sadly, there has been a human cost. Perhaps the most infamous scheme, run by Bernard Madoff in the United States, reportedly cost investors as much as $65 billion. For his trouble, Madoff received a 150 year jail sentence in June 2009.

Simply, ‘If it looks too good to be true, then it probably is.’

The price is right

‘Anchoring’ is another simple way that we lose perspective. Any advertisement that follows the simple formula ‘recommended retail price $50, now $30—save $20,’ is trying to influence our judgment by using an initial anchor price of $50 to show what a good deal is now being offered.

The technique is also used by some real estate agents who, when observing a potential buyer’s interest in a property, will casually mention that the vendor is looking for a price a good 10–20 per cent above what the vendor will probably accept.

Anchoring plays a big role in the stampede of every big market downturn. In late 2007 the Australian share market (S&P ASX 300 Price Index) peaked around 7000 points. It’s now somewhere around 4300 points, depending on which day you look.

Three years ago, 6000 points seemed low. Now it seems high. Our perspective has changed. To get back to 6000 points in the next, say, five years would mean a good, healthy rate of compound growth.

The good news is there are effective strategies to help us keep perspective, whatever happens in markets.

To get ahead we need to deal with today’s reality, rather than anchor on the past. Remember the only investment value that truly matters is the one you achieve when you sell. So be aware of price anchors, by  all means, but don’t base decisions on them.

We’re overconfident (and we don’t know it)

Anchoring is made worse by our habit of being over-confident in our abilities, particularly with money. So we need to know our own limitations.

Psychologists believe that overconfidence is much more common than most of us care to admit. For example, most people rate themselves as ‘above average’ at everyday tasks like driving a car, when this is statistically impossible. Clearly, not everyone can be better than average.

Confidence is good but within limits.  Overconfidence contributes to the tendency of many investors to:

• try to do it themselves, without the right skills and experience
• make decisions too rapidly, without sufficient analysis
• fail to diversify portfolios enough, hoping that one big bet will pay off
• buy and sell investments too frequently.

This helps explain why mature women are better with money than young men: young men suffer more from over-confidence than do mature women.

One of the leaders in behavioural finance, Terrance Odean of UCLA in the US, analysed the trading activity of 10,000 accounts of stockbroking clients. He found that on average, the shares that investors bought did worse than those they sold. In other words, most investors would have been better off sticking with what they had than flipping between investments (which also racks up transactions costs). This is why, even during boom times, up to 70 per cent of market day-traders may actually be losing money.

Technologies like the internet make this worse. Not only can you think impulsively, you can now act impulsively, trading online instantly. Odean found that investors who moved to online share trading actually

traded more, speculated more, and achieved lower returns than those who didn’t.

So while in bad market conditions, there may be a terrible pressure to ‘just do something’, buying and selling investments to scratch this itch probably won’t help -  and may well hurt.

Golden principles

One way to combat these behavioural traits is simply to be aware of them. But unlike the exciting fly-by-night investment schemes we mentioned earlier, the main strategy to take control is seemingly ‘dull’. Set your money strategy based on what the world is like today, and adjust plans as circumstances  change (which they will do constantly).  No financial strategy can afford to be ’set and forget’.

Successful investment approaches through history have applied four Golden Principles:

• buy good quality investments
• try not to pay too much
• diversify widely so no single investment can bring a portfolio undone – and gains can still be captured
• give it time.

A boring, conservative approach? Maybe. But one that provides a good chance of success in the long run? We think so.