Investors dumped shares in alarm on Friday, sending markets plunging as fears of debt defaults bred fresh concern for the world economy after Dubai’s shock request to suspend major loan repayments.

Investors “headed for the exit door” after the Dubai government’s investment vehicle Dubai World sought to suspend debt payments for six months, IG Markets analyst Ben Potter said.

Asian, European and US stock markets fell sharply as investors were spooked by the news, analysts said. The price of oil slumped to a seven-week low point close to 72 dollars and the dollar struck a 14-year low against the yen.

“The news of Dubai World raises some serious questions about where the global economy truly is at the present time and, most importantly, the effect this will have on market sentiment,” said Chris De Pury of specialist property law firm Berwin Leighton Paisner.

It has “reminded people that the underlying fundamentals have not changed, but it should not come as a surprise and it won’t be the last such large scale default,” he added, in a note.

“The question now is the extent of the drag on the wider global economy.”

Hong Kong slumped almost five percent by the close and Wall Street indexes fell more than two percent at the open.

Tokyo dived 3.22 percent, hit also by the yen striking a fresh 14-year high point against the dollar, which is bad for Japanese exporters.

Europe’s major stock pulled up in late London trading after earlier extending the losses of Thursday, when they had plunged by more than three percent in shock at the Dubai request.

In late afternoon European trading, London’s benchmark FTSE 100 index of leading shares was up 1.18 percent at 5,255.45 points, one day after falling by its sharpest amount since March.

Frankfurt’s DAX 30 added 1.24 percent to 5,682.77 points, and in Paris the CAC 40 rose 1.46 percent to 3,733.01, pulling back from a drop of almost two percent shortly after the open.

Analysts said the news from Dubai was a major blow to the emirate’s image but would have little lasting impact on other Gulf states, and others played down the impact on major banks with loans in the region.

But jittery investors Friday dumped stock in the two foreign banks with the heaviest exposure to Dubai — HSBC and Standard Chartered — as ripples from a feared debt default spread worldwide.

In Hong Kong trading HSBC dropped 7.6 percent to 87.00 Hong Kong dollars (11 US dollars) and Standard Chartered fell 8.6 percent to 185.90 Hong Kong dollars.

The Financial Times described Dubai’s shock announcement as a “serious misjudgment or, more likely, a breathtaking cock-up.”

The financial daily said the Dubai government’s decision “leaves a trail of unanswered questions that has done real damage to its reputation.” Related article: Foreign banks in the firing line

“Of all the glitzy emirates on the western shore of the Gulf, Dubai is easily the brashest. With the grenade it has just lobbed into the capital markets by calling for a six-month creditor standstill for Dubai World, it is effortlessly living down to that reputation,” the FT said.

Analysts at Exane BNP Paribas said that “so far the situation in Dubai seems contained, but a rise in government bond yields due to a higher risk premium because of soaring budget deficits is one of the main risks” for 2010.

Investors Behaving Bad

There is a long list of academic theories and models that attempt to explain and understand the economy and markets. While none are perfectly infallible, many nevertheless have their merits and provide important practical lessons.

One of the most exciting and fastest growing areas of research is in the field of Behavioral Finance, which seeks to understand how we approach investing by applying the lessons of psychology. While most other economic schools of thought assume that investors are rational, sensible and well informed, behavioral finance acknowledges that we are emotional beings who often exhibit impulsive, irrational and sometimes self destructive tendencies.

While a thorough and detailed review of the field is not possible in this forum, I would nonetheless like to outline some of the major findings from this area of research. Hopefully this will allow us to better understand our motivations and allow us to avoid making poor investment decisions. (For those who are interested in a more detailed review, I highly recommend the book “Behavioral Investing: A practitioners guide to behavioral finance” by James Montier).

Below are some of the more common biases we tend to exhibit as investors.

1. Short term focus

Humans are highly focused on the short term, and will most often choose immediate satisfaction over long term gratification, even if the latter is objectively a more rewarding proposition. This means that we often opt to lock in small profits today rather than allowing our investments time to grow into something more substantial. Furthermore, it means we are easily scared off by short term losses even if there has been no fundamental cause for alarm.

2. Herd mentality

   We are all hard wired to go with the flow. None of us like to act in opposition to the general consensus, and find it much easier to behave in a way that is consistent with our peers. This means that we are easily carried away by irrational exuberance and overly sensitive to crippling pessimism. Although it has been repeatedly demonstrated that the best time to invest is during periods of great pessimism and the best time to sell is during periods of unbridled optimism, the vast majority of us do the exact opposite.

3. Overconfidence

   It is easy to demonstrate that most novice investors tend to fare very poorly, but this fact does little to discourage people from diving head first into the markets with little understanding or planning. We all tend to see ourselves as “above average” and assume that we will be smart enough to avoid the stupid mistakes made by others. Furthermore, when investments go our way we chalk that up to our amazing skill and insight. When the market moves against us, it is simply bad luck. This means we often fail to recognize mistakes as mistakes, and are doomed to repeat our past errors. The lesson here is to remain as realistic as possible, and don’t fool yourself into thinking that you have special abilities above that of the ordinary person.

4. Heads in the sand

   We all love to hear things that agree with our own opinions and reinforce our beliefs. More importantly we loathe anything that disagrees with our outlook and tend to dismiss it as unimportant, or often simply wrong. The truth is that we do ourselves a serious disservice by ignoring information purely on the basis that it disagrees with our own view. Investors who limit themselves in this way are destined to fail at evaluating events in an objective and considered fashion.

5. A focus on the irrelevant

   Our brains have evolved to identify patterns, and indeed this has provided us with an important survival mechanism. Unfortunately though, we are often prone to see patterns where none exist and in contradiction to what a more thorough and balanced analysis would tell us. Many people base their investment decisions on price alone, while others look to the heavens and use astrology as the basis for their decisions. Because unrelated phenomenon will inevitably align from time to time, we will most often view this as validation, and in conjunction with the previous point, will fail to consider anything that questions the assertion. Investors would do well to ignore any investment style or technique that is not strongly supported by evidence.

6. I know best

   Many experiments have shown that we tend to give more weight to our own experiences than we do to the experience of others, or even rigorous statistical evidence. The classic example is with someone who has smoked all their life and never gotten sick, or who has a parent who smoked 10 packets a day and lived to be 100. Despite the fact that the dangers of smoking are well established, they will disregard the facts because it doesn’t match their own experience. Similarly, if someone has lost money in the market then they believe that share market investing is a dangerous and reckless exercise. On the other hand, those that have done well recently will mistakenly believe that it is easy and relatively straightforward to make good money trading shares. The truth of course lies somewhere in between these two extremes, but few people are accepting of evidence that does not agree with their own experience.

7. The endowment effect

   It seems that ownership tends to drastically distort our perception of value. That is, we tend to attribute a greater than reasonable value to something purely on the basis that it is ours. This gets us into trouble when we own shares that are performing poorly. We tend to assume that the market has made a mistake, not us, and that the price will ultimately recover. Sometimes this will even cause us to buy more stock in the hope of “averaging down” our losses. Smart investors do not become emotionally attached to their shares.

We cannot change the fact that we are emotional beings, and nor would we want to. The point is that investment decisions should be driven primarily by reason and objectivity. That is, although it may be easier said than done, you should invest with your head, not your heart. The best way to do this is to establish a very clear strategy prior to entering the market. Map out in advance what it is you are looking to achieve and have a clear plan of action to respond to all likely scenarios. This way you will never be taken by surprise, and will be less likely to act irrationally and emotionally.

Make the markets work for you