Shift your investment decisions from the emotional to the cognitive via a disciplined, rational allocation methodology

By PHILIPPA HUCKLE, Published June 20, 2007

IT'S carnival time for China stock markets. On the back of a massive 130 per cent rise in 2006, the market is up another whopping 50 per cent this year - spurring millions of breathless new investors into the market in record-breaking numbers. A total of 4.78 million new A-share trading accounts were opened in the first quarter of 2007, compared to 3.08 million for 2006. In April, another 4.5 million new accounts followed.

A local programme, Stock Market Today, clocks some of the highest television ratings in Shanghai. CCTV state television regularly features clusters of elderly investors, college students, office workers and retirees clamouring over profits to be made trading stocks. Southern Weekend reports that people are frantically pulling their money out of real estate to pile into stocks.

The bull market is feverish. Even senior Chinese official Cheng Siwei warns against 'blind optimism'. Quite right: the market's average price-earnings ratio has soared above 50, making it nearly three times more expensive than Asia's average. As tycoon Li Ka-shing says: this 'must be a bubble'.

What causes investors to ignore the abundant danger signals accompanying bubble markets? The reasons are psychological. As investing legend Warren Buffet says, to invest successfully, you need 'the temperament to control the urges that get other people into trouble in investing'.

Since the time of Aristotle, scientists and philosophers have identified two major motivational systems fundamental to human behaviour: reward-seeking (pleasure-motivated) and loss avoiding (pain-avoidance). In overdrive, amplified reward-seeking manifests as greed; amplified loss avoidance as fear. Fear and greed are extremely dangerous in investing. They cause investors to euphorically pile into expensive markets and despairingly bail out of cheap markets - instead of buying low and selling high. Yet by understanding the origins of these destructive emotions, you can begin to avoid them. Neuroeconomics is a cutting-edge branch of finance which uses sophisticated imaging techniques to explain how the emotions of fear and greed originate in the brain's limbic system, the source of human emotions.

Reward-seeking behaviours are generated in brain via dopamine. Dopamine is a 'pleasure' chemical. It's activated by the anticipation of reward (food, money, sex etc). Dopamine feels delicious; it creates powerfully positive feelings of confidence and high energy which spur humans to go for rewards. The more luscious the reward in sight, the bigger the shot of dopamine released.

The prospect of giddy stock market rewards are likely infusing many China investors with a significant dopamine rush right now. Neuroscientists have also shown that the purpose of another area of the brain is to search for patterns. Humans are inherent pattern-seekers: just two iterations of a sequence triggers the brain to extrapolate forward - so, the more a market is going up, the more inevitable the upward pattern seems.

But as dotcom investors learned, the heady cocktail of dopamine- fuelled pattern-seeking is extremely dangerous: the more thrilling the recent returns, the more powerful the urge to join the party. This is why new account openings and trading activity accelerate the higher a market climbs. Greed kicks in.

Yet if an anticipated result does not occur (if the market stops going up), disappointment occurs. Chemically, disappointment depresses brain serotonin levels - and decreased brain serotonin levels, in turn, cause feelings of anxiety, depression and despair. These trigger the brain's loss-avoidance system, prompting fearful, risk-averse behaviour - which pushes investors to end these painful emotions by selling the investments triggering them.

Then, as prices dip, the brain reverses its pattern-extrapolation: now it seems that the more a market goes down, the more likely that it must continue to go down. And the sharper and more sudden a fall, the more fearful the loss averse behaviour. So fear and panic take hold, compounding the primal psychological urge to sell, sell, sell.

The mechanics: eager anticipation triggers a dopamine release, so investors buy, causing prices to rally. Yet once the anticipation is ended, serotonin levels fall. In response, investors sell - and prices fall.

In many aspects of life, the pleasure/pain systems of the human brain serve as an essential survival mechanism. They generate emotions that spur humans on to pursue rewards while steering clear of danger and loss. Yet emotions are a terrible barometer for investment decisions - because they counteract the objective of buying low and selling high through cyclical market movements.

While we cannot prevent our emotions occurring, we can neutralise (or reverse) their destructive impact. You can shift your investment decisions from the emotional to the cognitive via a disciplined and rational allocation methodology.

Firstly, diversify your capital into a structured asset allocation properly formulated across uncorrelated market cycles. Secondly, applying a disciplined rebalancing policy to the allocation forces systematic profit-taking from maturing cycles, and a consistent repositioning into cycles next due to bloom. Ultimately, rebalancing your asset allocation achieves Mr Buffett's mantra: 'To be fearful when others are greedy and to be greedy when others are fearful.'

The writer is CEO and founder of The Philippa Huckle Group