In a note to investors, AMP Capital chief economist Shane Oliver said individual investors are often prone to "lapses of logic" that can end up damaging their portfolios.
Examples of such behaviours include playing down uncertainty; focusing on sharp rises and falls in certain markets; ignoring new information that contradicts past decisions; and giving more weight to personal experiences.
Mr Oliver explained that mass communication and interactions with friends and colleagues means these lapses of logic can become “contagious”, with many investors getting their information from the same sources.
“Naturally, the result is magnified if many investors make the same lapses of logic at the same time, as part of a crowd,” he said.
Investor optimism tends to push an asset class until a point where “everyone who wants to buy has” and a small bit of bad news will tip the market down, he said.
“The whole process goes into reverse once buying is exhausted, often triggered by contrary news to that which drove the rise initially,” he said.
Mr Oliver noted that at the other end of the cycle, however, when an asset class is “cheap and unloved”, investors are presented with the best opportunity to buy and the market moves upwards once again.
Being aware of past booms and busts in a particular market will go a long way to avoiding potentially damaging overreactions; likewise, investors who understand their own decision-making process will be better positioned throughout this cycle, he said.
Mr Oliver added that sticking to a broad strategy and not changing the approach throughout surges and plunges in the market rather than following the crowd is the best strategy.
“If you are tempted to trade, do so on a contrarian basis. Buy when the crowd is bearish and sell when it is bullish,” he said.
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