Why our instincts make us poor investors
07 August 2017
An edited version of this article was published in the 7 August 2017 print issue of TODAY. (Online version released 5 August.)
“You can take man out of the Stone Age, but you can’t take the Stone Age out of man.” This quote from the Harvard Business Review has become increasingly accurate in the nascent field of neuroeconomics, which combines the disciplines of neuroscience, psychology and economics to look at how economic decision-making actually happens inside the brain.
Evolutionary psychology has revealed that our mind was designed by natural selection to solve adaptive problems faced by our hunter-gatherer ancestors. As such, our brain is superb in recognising short-term trends (predicting where food can be found) or generating quick reflexive emotional responses (escaping from predators). Unfortunately, these same responses can cause our downfall when we think about money and investing.
Research by Dr Jordan Grafman at Northwestern University and Dr Hans Breiter at Harvard showed that telling people they were losing or expected to lose money triggered the brain’s amygdala and hence their fight or flight response. If this caused you to dive into a pond to escape a swarm of bees, this response could save your life. But in the investing world, dumping your stocks in panic and “running to safety” when the markets fall could act against you.
This typically happens when the pain of loss becomes too great, which is usually at market lows, causing investors to miss out when the market bounces back. Activity in the amygdala also triggers the release of adrenaline, which is known to consolidate our memories of fear and anxiety. That is why you are likely to vividly recall emotionally-stressful events like a market collapse and your investment losses, but forget your purpose for investing which you established in calmer moments.
This also explains the market reaction during boom and bust cycles – market crashes are usually swift and sudden, but the recovery period is much slower, as investors have been scarred and therefore less eager to participate in the recovery.
Our brains are also wired to search for patterns to try and predict outcomes. If you presented a random series of numbers, faces, letters – basically anything, most people will claim they can predict the next item in that series. The anecdotal evidence is everywhere: thinking that we are “due” to hit our jackpot in TOTO after a few close shaves (although the probability is still 1 in 13 million), how we are “sure” that the next card we pick will be a “10” after the previous card was a small number, how we are certain it will rain in the afternoon if it has done so the past 3 days, etc.
That’s why technical analysts will vehemently insist that charts of past stock prices can predict the path of future market returns, and why every market strategist is sure he can forecast the price of gold, technology, healthcare, etc. just by studying its past patterns.
Dr Scott Huettel of Duke University discovered that our brain (in particular the anterior cingulate) begins to anticipate another repetition even if a stimulus occurs only twice in a row. The feeling of “I know what’s coming next” kicks in, and we automatically assume three or more repetitions. It also showed that the longer the pattern repeats, the more violently our brains respond once that pattern is broken.
In an investing context, the moment “growth” companies start to falter after consecutive quarters of good earnings, investors start jumping ship – causing big movements in share prices. Also, we get lulled into a sense of comfort when stock markets slowly grind upwards over a long period.
However, when stock prices then start to decline, our brains react strongly to this broken pattern. Coupled with the panic trigger (and accompanying adrenaline rush) from the amygdala, this causes an immediate emotional reaction without first allowing the analytical part of the brain to respond. Pattern recognition also helps explain why value stocks are consistently underpriced. Earnings from these companies are usually lumpier and are not consistent. Our brain finds this unpredictability hard to grasp, and as a result, investors struggle to price these stocks accurately.
Our brains also love chances; the more obscure the better. The chance that the stock you bought could go up 100% or that your Singapore Sweep ticket could strike $2 million is what keeps us coming back for more.
A study by Dr Wolfram Schultz at the University of Cambridge showed that the possibility of getting a reward fires dopamine neurons in the brain, producing a “high”. That’s why we defy logic and poor odds to continue buying the lottery, investing in IPOs, concentrating in one or two stocks and shunning “average” market returns. The possibility of being the next “Peter Lim” or buying the next “Facebook” helps keep our wallets open. Financial anticipation fires up the nucleus accumbens, which is the same part of the brain that causes cravings in cocaine addicts. Think about the time you were profitable from a lucky trade. It is likely you felt a euphoric “buzz”!
So, how do you use these insights to make you a better investor? First, recognise that we will never be able to change how our brains work. Psychologists will tell you that a good way to eliminate a bad habit is to substitute it with a better one. Therefore, instead of giving up your habit of betting on the next hot tip, use a different (and smaller) wallet to limit any losses. Or, establish a dollar-cost averaging plan that automatically buys into a proper diversified portfolio every month, rain or shine.
Second, cut out as many destructive triggers as possible. For example, stop watching stock tickers, CNBC, Bloomberg or anything that might invoke investing panic.
Finally, meet regularly with a trusted friend or financial adviser who can help stave off panic fears and keep you grounded as to your original purpose of investing.
(This is part of a series of articles that we have been writing for Singaporean investors.)
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