Up until an hour ago I thought I knew something about the sharemarket. But then I spoke to a philosopher and now I know that I know nothing.

The really frightening thing is that he is convinced even the most sober, well-informed experts consistently make poor investment decisions.

Peter Slezak is a philosopher and cognitive science expert who has strayed into the relatively new field of behavioural finance. When he examines the stockmarket, he does not see dollars and sense but the little grey cells of both novices and professionals madly misfiring.

Behavioural finance examines investor behaviour, with a little help from social and behavioural psychology.

"When we process information our minds are programmed to make certain simplifying assumptions, and sometimes these assumptions let you down," Dr Slezak says.

"In the context of finance, you can pore over pages of factual data yet the decision you make may still not be the most logical or the right one."

According to this school of thought, all humans make the same errors of judgment that can cause stocks to be overvalued or undervalued.

By understanding these mistakes, investors can avoid making them and profit from the faulty thinking of other investors.

Analysts are aware that share prices do not always reflect the fundamental value of a company, but they tend to attribute any investor behaviour they cannot measure or understand to "market sentiment", with the implication that sentiment is irrational.

Far from being irrational, Dr Slezak says herd behaviour is often a rational response for individual members of the herd.

Take the example of fire breaking out in a crowded cinema. Theoretically, more lives would be saved by an orderly evacuation. But we all know that most people in the cinema want to save themselves and perhaps their loved ones first, so they trample over fellow cinemagoers to get to the exit first, consequently blocking the exit.

For an individual, bolting for the door is a rational decision even though the crowd appears to be behaving irrationally.

Behavioural finance has developed from the work of Daniel Kahneman and Amos Tversky. Basing their research on hundreds of experiments, they found that most people feel much more pain from losing $100 than pleasure in winning $100.

In fact, people feel the pain of losing money three times as keenly as the joy of earning money.

This is not to say that most people are risk averse, but rather "loss averse". Most people prefer a smaller certain gain to a larger uncertain gain, and a larger uncertain loss to a smaller certain loss.

To see this phenomenon in action, you need look no further than the investment community's rediscovery of dividends.

Faced with the prospect of low, or no, capital gains from shares for the foreseeable future, investors are now chasing shares that offer small but certain rewards in the form of regular dividend payments.

Dr Slezak describes share investing as decision-making under uncertainty. Most investors understand that the sharemarket is a risky place, but Dr Slezak says the concept of risk better describes gambling in a casino where the odds of winning and losing can be mathematically calculated. Unfortunately, there is no way of calculating the odds of a share price - or the market - going up or down tomorrow.

So where does that leave investors who want to know whether the market is close to hitting rock bottom? Between a rock and a hard place, if you rely on philosophers.

Luckily, some people have learnt to make peace with market uncertainty. Geoff Davey, of ProQuest, a company that provides risk-assessment software to financial planners, says that despite popular opinion to the contrary, markets are probably less risky now than they were two years ago.

Mr Davey believes investor behaviour is determined by a combination of their risk tolerance, their perception of risk and the goal they are trying to achieve.

He says many investors, and their advisers, did not understand the risks they were taking when the market was overheated. However, a ProQuest study of 20,000 risk profiles between May, 1999, and February, 2002, showed no marked change in risk-tolerance scores, despite plummeting market sentiment.

To describe the difference between risk tolerance and perception of risk, Mr Davey resorts to surfing terms.

He says most surfers - himself included - have made the mistake of surfing at night after too many drinks. Once.

"Until you've done it, you don't realise how risky it is," Mr Davey says. "(After almost losing my life) my risk tolerance (for surfing) hasn't changed, but my perception of the risks has.

"People didn't see the markets as risky in the late 1990s. How could you, if that (a boom) was your only experience?"

Hopefully, if investors stick to their investment plans and resist the urge to abandon their shares completely, they won't make the same mistakes next time.

When markets move substantially in either direction, the accepted wisdom is to rebalance your portfolio and stick to the asset that best reflects your risk tolerance and investment goals. Call me muddle headed, but that seems like sound advice.

Barbara Drury is the author of Personal Finance for Dummies (Wiley, $39.95).

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