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ONE OF the realities of markets is that at any one time, there has to be at least two individuals who are taking completely opposing views as to what is likely to happen next.

While one person will look at the economic data and think the worst, another will look at the same data and interpret it in a completely different way – think of it as the glass half empty, or half full. One will see a disaster, the other an opportunity.

This difference of opinion will ensure that markets continue to thrive, after all, the adage that “two views make a market” is, at a very basic level, what keeps the economic wheels turning. But which one you will be depends on everything from your previous investing experience and understanding of the sector you are investing in, to your current financial and emotional commitments. But it seems we are not spending enough time thinking about how we deal with our finances.

Professor Janet Reibstein, a psychologist who specialises in commitment and relationships, said: “[The Standard Life report] Your Commitments, Your Future shows a discrepancy in how much attention we devote to our financial and emotional commitments. We spend over two hours a day thinking about emotional commitments, but just 37 minutes on our financial commitments.

“People consider financial commitments as something abstract, separate to their emotional life. But our finances underpin our most important relationships and often our ability to achieve our future goals. The Standard Life report makes it clear how vital it is for people to engage with their finances, their personal relationships and future aspirations as one single entity.”

Even if you try, or think you succeed in eliminating emotion from your financial decisions, it is almost impossible to do, especially if you are relying on the money you are investing for a specific reason, such as retirement or paying your child’s school fees. The closer you get to that date, the more important it will be that nothing goes wrong with your investment – so the emotional pressure for it to succeed becomes greater.

There is an inherent part of human nature which makes most of us more comfortable if we are acting along the same lines as many others. This ‘herd’ mentality is not for everyone, there are some very successful contrarian investors who prefer to go their own way. However, this herd mentality is one of the key factors in the creation of investment ‘bubbles’ in the markets.

Often investors want to believe that something is going to happen, and that ‘shared’ optimism is what leads to assets being over valued. For example, in the last 15 years there have been a number of bubbles – the tech bubble in the late 1990s, the property bubble fuelled by sub-prime lending in the States to mention just two – many of which would not necessarily have been seen as bubbles until the markets turned, investor confidence faded rapidly, and prices crashed.

US investment giant Vanguard has characterised its model of a bubble into four stages. In a report earlier this year, it said: “In Stage 1, investors develop initial forecasts of asset prices based on errors in statistical inference, broadly captured under the idea of the representativeness heuristic (where ‘heuristic’ means a decision shortcut).

“In Stage 2, these forecasts of future price appreciation become exaggerated. Overconfidence and excessive extrapolation of recent positive experience come into play.

“In Stage 3, individual forecasts influence the behavior (sic) of the group (in this case, the market or financial system as a whole). Through a process known as group polarization, the financial system takes on higher risk exposures than individual members would separately agree is prudent.

“Finally, in Stage 4, as actual market data begins to undermine the group’s overconfident forecast of the future, the group polarization process plays in reverse, and the collective market outlook shifts sharply to the negative.”

At Vanguard’s stage 2 in the process, the tendency for an improvement in the price of a stock or sector in the short term can be extrapolated farther into the future than perhaps is deserved. This overconfidence is a well-recognised phenomenon in investing, and is aligned with an overconfidence in other areas of our lives.

Vanguard’s report continued: “Overconfidence is perhaps the bestknown bias in behavioral finance. It is found in a wide range of human decisions, financial and nonfinancial. On a number of dimensions, most individuals tend to rate themselves as above-average. For example, most drivers, joke tellers, and students rate themselves as better than average. The tendency to view oneself as above-average extends to professionals, including CEOs, managers in general, doctors, negotiators, investment bankers, and entrepreneurs.

“Overconfidence has been linked at the margin to gender. Men, on average, appear to be more overconfident. For example, they trade more in brokerage accounts—and generate inferior results—compared with women, who are more likely to be buy-and-hold investors.”

However, it is the same herd mentality that causes bubbles to form that pops them so effectively in a short time – when sentiment turns, the majority of investors will look to sell rather than hold, as that appears to be the ‘right’ thing to do.

So, given how many people get ‘burned’ when one of these bubbles eventually bursts, you might wonder why these cycles are repeated time and again, in different markets but with the same painful results? Human nature tends towards being positive, and hopeful. It is also, unfortunately, to try to convince ourselves that ‘it could not happen again’, or ‘it is different this time’.

This bias is what has caused millions of investors throughout history from the South Sea China bubble to the property bubble in the USA in 2007 to make the same mistakes time after time. It comes back to the emotion that we use when we are making all of our decisions, including investment ones. No matter how hard you try, there will still be some emotion in your investment decisions, and that can mean you making a choice more with your heart than your head.

The most successful investors are the ones that have a solid foundation for their reasoning, a clear understanding of why they have chosen their investment and what they expect to get, and the exact point at which they will take profit – no matter what happens. Investing in what you know can help with this decision-making process, and will inevitably give you a better understanding of how a stock or sector is likely to behave. It will also help you to understand the impact of the wider economic environment on your holdings, and help you to be more cool-headed than others.

Feeling in control of your finances is directly linked to your self-esteem, according to a study by Aviva last year in association with a psychologist at the City University in London. Nearly nine in 10 of those surveyed with high self-esteem also felt in control of their finances, while seven in 10 with poor self-esteem felt they had no control of their financial affairs. Taking control of your financial affairs is not only going to be good for your wellbeing now, it will give you peace of mind for the future. If you cannot do this for yourself, then consider getting some assistance from specialist.