Diary Of A Private Investor: Fear and greed can harm wealth

The investor's mind may be steeped in prejudice and emotion, but all need not be lost says a financial guru

Trust the Americans to undermine one's confidence. Just after I refined my personal investment research system to the point where even I understand it, set up risk parameters with which I am comfortable and replaced hopes with indisputable facts, along comes an American and sows a seed of doubt. According to H Bradlee Perry my mind is often unreliable and therefore I process information illogically.

Trust the Americans to undermine one's confidence. Just after I refined my personal investment research system to the point where even I understand it, set up risk parameters with which I am comfortable and replaced hopes with indisputable facts, along comes an American and sows a seed of doubt. According to H Bradlee Perry my mind is often unreliable and therefore I process information illogically.

In fairness I must point out that Bradlee is not being personally insulting because as far as I know I have never met the fellow. He is referring to investors in general - whether individual or professional - who believe that they analyse companies carefully and then make a rational judgement on whether or not to buy their shares.

Many of us, according to Brad, just can't do it. Far from being unemotional and calculating in our deliberations, we can be moody, petulant and selective in our choice of facts. In other words, driven by fear and greed, our decisions are based on what we want to decide rather than what we should decide.

And Brad is a man who knows of what he speaks. He's a well-respected investment guru in the US and former chairman of a large investment counselling group.

Before you succumb to the "but he doesn't mean me" syndrome you should know that there are so many of us flawed investors about that we can move markets. "Experience shows that emotional bias and mood shifts are mainly responsible for the short-term and intermediate-term swings in prices of individual stocks, and the market as a whole," he says. He cites the example of Yahoo! which more than quadrupled in a four-month period at the end of 1999 and then plummeted 86 per cent by the end of 2000.

Brad is philosophical about our shortcomings. "Let's face it, thinking rationally about complicated subjects is hard," he says. "Various studies have shown that the human mind is often unreliable for processing information logically. Part of the reason is people's strong tendency to use what psychologists call heuristics, the rules of thumb or mental shortcuts our minds make to simplify decision-making.

"Investors tend to make decisions based on their perceptions, which often stem from recent and limited anecdotal information, their own experience (which may be long or short, extensive or limited) and other mental shortcuts."

Brad bangs on about his theories, and supports them with examples, for seven pages on his company's website, so if you want his thoughts in more detail log on to dlbabson.com. Meanwhile, for those of us who just accept our shortcomings and want to do something about them, here are the three Bradlee remedies:

First, be aware that greed and fear, particularly under different stock market conditions, will always overcome rationality. A chap called Tom Watson, not the golfer but the man who built the vast IBM empire, insisted that every employee had a plaque on his desk saying simply "THINK". Investors must think carefully.

Second, make sure you invest in companies and not shares. A company is something that can be analysed logically. Study the products and services and the markets for them, their competition, their financial trends, their long-term history and everything else factual you can think of. Restricting yourself to these realities will fend off emotional distractions. Shares are just bits of paper and their value moves erratically, influenced not just by business fundamentals but also investor emotions.

Third, pay close attention to the market valuations of companies. Be aware that high valuations contain a lot of emotional fluff - witness the dot.com debacle - and the fluff will be blown away the minute investors start to huff and puff. On the other hand, low valuations usually include an emotional discount that can pay off handsomely if investor dislike disappears.

When properly recognised, the presence of these love and hate emotions can be utilised along with fundamental analysis to make excellent investment decisions, by doing the opposite of what emotion is saying, Brad concludes.

Despite the dent Brad has made in my self-belief I have this week been investigating two shares which I would suggest you take a closer look at.

Rather like the people who are its customers, McCarthy & Stone seems to have been around forever. For the last two decades it has dominated a niche market in the home-building business because it provides a final nesting-place for those who have reached a time of life when they can cease the daily toil.

M & S caters for the over-60s, a sector which in a few years time will account for 40 per cent of the population. Each of the flats it builds includes features which appeal to this age group.

Security systems operated via the television, alarms on every flat-door and ground-floor windows, 24-hour assistance alert, plugs at a convenient height, washing and drying machines with doors that open at waist height, taps that are operated by levers.

The firm has 80 developments on the go, it builds around 1,500 flats a year at an average price of £90,000, and chooses level sites near shops and public transport.

It's a recipe for success and the figures prove it. Profits and earnings have grown steeply and steadily over the last five years. Dividends too have never veered from an upward path and the return on capital employed, at around 30 per cent, is one of the best in the building industry. Top that good news with a p/e ratio of just over 7 and you can see why I really like the look of this company.

The same goes for my second suggestion, Macdonald Hotels. Although I am not a great fan of the leisure and hotels sector, partly because the return on capital is low, this group deserves close scrutiny.

It is one of the newer fellas in this business and only came to the market in 1996. But the management, led by a chief executive with the delightful name of Donald Macdonald, is mainly ex-Stakis and therefore experienced. The company operates around 68 hotels in Britain, of which 26, with a total of 1,900 rooms, are owned directly. The rest are managed for other firmly funded owners.

All the fundamental figures (with the exception of the gearing which at 63 per cent looks rather high) seem good. The forecasters believe profits are set to rise and consensus opinion among the brokers is that, at around 173p, the share is a buy. My only reservation was that the Macdonald Group has involved itself in the time share business by acquiring a 50 per cent joint venture share in Barratt International Resorts.

As one who acquired his initial investment capital from the time share industry, I should be enthusiastic because there are good profits to be made and Barratts is one of the biggest and the best operators. But there are pitfalls, notably in the maintenance charges and resale values, so the point was worth investigating.

Having discussed this with a Macdonalds director I am now relaxed about the association. The hotel group has been managing the Barratt time share resorts for 10 years so the game is not new to them. A clause in the original contract enabled them to acquire half the time share company at an advantageous price and now the joint venture contributes around £1m to the Macdonald bottom line.

terry.bond@hemscott.net