Skandia UK - On your best behaviour

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Do you let your heart rule your head when it comes to investing? Here we explore some of the common mistakes and how to avoid them.

How did you respond to the credit crunch in 2008 and the volatility it continues to bring to the market, as seen this summer? You may have rushed to move money from share-based investments into bonds and cash and taken money out of your stocks and shares ISAs. Alternatively you may have opted to remain in the market, either riding out the bumps or trying to exploit investment opportunities.

Whatever your reaction, the past 12 months have highlighted how people behave around money. Graham Bentley, Head of Proposition at Skandia, believes the 'behavioural biases' of investors have become more visible.

"The rational approach is to take the rough with the smooth and realise that you invest because generally the market goes up. If you have a portfolio with a potential 20-year return, you should recognise that this is a rare period which happens only once in 15 years," he says.

"It's understandable, however, that people might panic when markets fall. Their reference point is the value of the market at its highest, not what it was when they first invested. This leads to investors suffering from a variety of biases."

Getting the timing right

As Graham points out, if you move out of share-based investments and into cash, you can end up selling low and losing money. "Moving into cash isn't a mistake. People have done well getting out of the market before crashes in the past," he says. "But if you panic during volatility and move your money, you might find you do so at the point when the market has gone as low as it is going, missing out on any rebounds. What's more, it can be tricky to judge when to re-invest."

The key is to remember your long-term strategy and not to let your heart rule your head. This may mean that you build into your strategy a point at which you will sell if your investments have fallen by a certain percentage. This might help you avoid becoming a victim of what Graham calls "regret aversion".

"If money is being lost in an investment, then people find it difficult to sell it in case it goes up in price the next day, when it could just as equally keep on falling. The swinging prices in a volatile market often lead to people holding onto rather than selling, even if an investment has lost value."

Don't follow the herd

Another type of behaviour that we see in both good times and bad is following trends in the hope of making a fast buck. As Graham explains: "People follow trends because they find it comforting. If everybody is buying into gold or oil, then other people will follow because surely 'everyone can't be wrong'. They are investing in the momentum they have seen. But there will come a point when the bubble bursts."

By the time most people have bought into a trend, chances are most of the rises have already happened and prices will either settle or maybe even start to fall. The same goes for buying into 'fads'. Speak with your financial adviser before jumping onto any bandwagon.

So what makes investors behave in these ways and what can be done in turbulent markets?

Mind over matter

"Investors are human beings. There is a part of all of us that says 'I don't want to lose money'. If we do, we are prepared to take a risk to play catch up," Graham says. "There is a point when people stop seeing their investments as real money, and that is where it can become dangerous."

He points out that similar problems affect fund managers. "At times it can seem they are no more prone to being rational than an average investor," he says. "They are also overconfident in selling and buying in volatile markets."

So what should investors do? Having a diversified portfolio is important. It would be a very rare set of events if every investment went down at the same rate at the same time.

"A knowing investor would have their attitude to loss measured in a risk profile and build their portfolio accordingly," says Graham. "They will then have to take the return in line with their attitude. Most investors want a portfolio that will make them the most money but then are shocked when the markets turn volatile. You can't swing from being positive when markets are up to negative when they are down."

Investors need to divorce themselves from what is happening in the market, which Graham accepts isn't easy to do.

"You should say 'I'm going to dictate what happens to my money in the next 10 years or so' as opposed to worrying about the present. Don't look at market prices every day," advises Graham. "Find out what you can tolerate and operate accordingly. It takes discipline to let the head rule the heart but you'll have fewer sleepless nights."