It is often said that fear and greed motivate investors, but few realise just how much they lose from being driven by these emotions to buy and sell at the wrong time.

We all know that investors should buy when markets are low, but research tells us that this rarely happens. 

John Ventre, manager of the Spectrum range of funds at Skandia Investment Group, says investors make on average three times less money than stock market indices, due to poor timing. 

"Over 20 years the SP 500 has produced 8 per cent. The average fund deducts about 1 or 2 per cent in fees, leaving a net return of 6 to 7 per cent. However, the average consumer return is just 1.9 per cent," he commented. 

Ventre claims one booming trend that investors have missed out on is technology.

"Over most periods technology funds have been a good investment, but most people bought them at the wrong time, about 10 or 12 years ago, and so their returns have been bad," he said. 

"They were sucked in on the way up and sucked out on the way down." 

Performance of sector over 20-yrs

Source: FE Analytics 

Research shows that investors are biased towards making decisions based on their own experiences of the recent past. 

In an experiment by psychologists Leaf Van Boven and George Loewenstein, people were told to imagine they were going backpacking and had to choose three days' food or three days' water. 

When they were asked just before exercising, 61 per cent chose water, but when they were asked just after exercise, the figure was 91 per cent. 

This illustrates the difficulty investors face when markets have been on a sustained run of poor or volatile performance – they are naturally inclined to assume the trend will continue.

This means that the next time markets go on a sustained rally, investors are likely to be caught in funds designed to protect against the current stagnant environment. 

Once they accept this is how their psychology works, how do they go about avoiding this pitfall? Calling the bottom or top of the market is not a solution – everyone is trying to do that, many of them professionals who are much more intelligent.

Ventre says that when investors are picking which fund managers to trust cash to, it is particularly important to subject their results and philosophy to stringent testing, deciding whether they have achieved their returns through the quality of their philosophy and style or merely through following the herd into the latest big thing. 

He commented: "You need to dig down and ask why a manager owns a stock – is it because he got lucky or is it due to his investment style? We ask whether a manager’s philosophy works and whether we can prove it to ourselves experimentally." 

The key, he adds, is for investors to change their way of thinking: "The best investors ask why I should hold this fund, not why I shouldn’t hold it." 

This means questioning the philosophy of the manager they are assessing, asking why they might fail and building up as full a picture as possible. 

By attempting to look for the problems with a fund, investors defeat their natural tendency to be over-optimistic and over-confident in their own judgment. 

Furthermore, psychological experiments in a courtroom setting show that when the prosecution’s case is presented first, in narrative form, the willingness of juries to convict is higher.

This implies people are likely to be more adept at resisting the movements of the herd if they first find out the reasons why the trend is likely to end in failure. 

Ventre explains that the higher the tracking error of a manager, the higher their information ratio, meaning that the less attention that a manager pays to a benchmark or index, the better their results. 

"That’s why the portfolios of the best investors tend to have the least similarity to their benchmark," he finished.