Capital Beliefs

 

 

 

Who you callin’ emotional?  We all know to buy low and sell high, but study after study shows we do the opposite. Why? Most people would correctly point out that investors fail to control their emotions. But this truth does more harm than good because it is an oversimplification that leaves out important aspects of reality. 

 

The fields of behavioral finance, neuroeconomics and biology have taught us that investment-related misjudgment doesn’t stem from raw emotions, rather, from mental misfires related to our intuition and reasoning systems. While these systems work well for the ordinary surroundings of everyday life, they often lead us astray in the counterintuitive and information-heavy world of investing.

 

If we first seek to better understand, and only then control, what ultimately impacts our decisions, we vastly increase the effectiveness of our actions. A 1947 speech by Benjamin Graham – arguably the most influential investment mind of the 20th century – underscores the importance of this subject: 

 

If you can throw your mind, as I can, as far back as 1914, you would be struck by some extraordinary differences in Wall Street then and today. In a great number of things, the improvement has been tremendous…one
respect we have made practically no progress at all, and that is in human nature. Regardless of all the apparatus and all the improvements in techniques, people still want to make money very fast. They still want to be on the right side of the market. And what is most important and most dangerous, we all want to get more out of Wall Street than we deserve for the work we put in.

 

Fast forward to today - perhaps not surprisingly, the evidence that investors continue to be their own worst enemies is everywhere:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Why is this problem so persistent? Put simply, our investment approaches are often unbalanced.  Too much time spent anticipating the behavior of the market, and not enough time thinking about what the market can do to our behavior. Lessons learned are too often learned the hard way. Or as Judith Stern said: “Experience is the comb life gives you after you’ve lost your hair.”

 

It's also in our nature to underestimate the work needed to balance out our approach. Warren Buffett sums up why: “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.” A real education includes learning that we don’t know certain things; but parts of our brain are hardwired to distort information in a flattering way, affirming to us that we know what we need to – even when we don’t.

 

Some of our most damaging information processing errors relate to our memory.  In Daniel Levitin’s book The Organized Mind, he writes:

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“Cognitive psychologists have provided mountains of evidence over the last twenty years that memory is unreliable. And to make matters worse, we show staggering overconfidence in many recollections that are false. It’s not just that we remember things wrongly (which would be bad enough), but we don’t even know we’re remembering them wrongly, doggedly insisting that the inaccuracies are in fact true.”

 

This problem is largely the result of evolution's impact on our brain’s built-in automatic energy-saving system, the subconscious. The human brain only comprises 2% of our body weight, but it uses 20% of our energy. Over many thousands of years, our brains have developed energy-efficient systems that filter and edit what we take in. These mental-shortcut tools are what helped us form quick assumptions on the best course of action. Very helpful for any human who happens to come across a crocodile-infested river, or a Steven Seagal movie on Netflix. Run! 

 

This usually-helpful information-simplifying system becomes a burden when our choices and consequences are separated by time. Because reason and logic are ways of assembling thoughts to bridge the gap between a choice today and future consequence, our natural desire to build consistent and affirming investment stories can be dangerous.  Nobel Prize-winning psychologist Daniel Kahneman sums up why: “It is the consistency of the information that matters for a good story, not its completeness. Indeed, you will often find that knowing little makes it easier to fit everything you know into a coherent pattern.” The less we know, the more prepared we think we are, even when we are not. 

 

This natural desire for a coherent story is a key reason why we humans are poor at predicting today how we will react to future stressful events. In fact, more and more studies from the field of behavioral economics demonstrate that seemingly-insignificant details have an outsize impact on our beliefs about the future. For example, one study reports that when investment losses were presented in red they felt more painful than losses of the same amount shown in black. People who viewed the losses in red were more likely to convince themselves that the investment would keep falling.

 

Insight from the emerging field of neuroeconomics – which blends neurology, economics and psychology – helps explain why something as simple as losses shown in red often impact us. With the help of imaging technology, scientists can now observe patterns in the neural activity of humans while they simultaneously make decisions. Because of neuroeconomics, we now have strong evidence that the rational parts of the human brain are often in tension with the emotional parts, found in the limbic area.

 

One neuroeconomic study compared the physical differences in participants brains to see how the participants might differ in making investment decisions. The first group had brain lesions that impaired their ability to properly manage emotional decision-making. The second group had normally-functioning brains. The group with brain lesions made more rational investment decisions than the group with normally functioning brains. In other words, a properly functioning brain was at a disadvantage in making good investment decisions.  

 

Anurag Sharma, author of The Book of Value: The Fine Art of Investing Wisely, summarizes how these challenges lead to a buildup of deficiencies in our investment thinking: 

 

Whatever their source and content, a particularly interesting feature of beliefs is that they can form quickly, and often on the most tenuous grounds. Modern psychological studies have shown that even when presented with data with which to make decisions, people usually rely on information that already exists in their minds, is easily recalled, or is readily obtained from sources nearby. In general, people also give more weight to information that is obtained first. This tendency to quickly form opinions based on only readily available information, and then to selectively seek and creatively use subsequent information to support initial opinions, is called the primacy effect...

 

For investors whose success depends on making good choices about where to invest their money and where not to do so, such psychological hindrances can be costly. Taken to the extreme, mistakes induced by poor thinking can be disastrous; pulled into an investment on a hunch, a belief-enhancing cycle can induce an increasing commitment of resources until all is lost.

 

This belief-developing system is so ingrained in us that even the best investors put procedures in place, in advance, to help counter its negative effects. To circle back to Buffett again, he says: “I always like to look at investments without knowing the price— because if you see the price, it automatically has some influence on you.” Buffett’s filter also highlights how apparently insignificant details can influence even the best investors. Identifying when our situational-thinking is likely to need mental guardrails or filters is a very powerful wealth building tool.

 

Psychologist Philip Tetlock – whose research has focused on what distinguishes elite thinkers from the rest of us – supports the development and use of good mental filters to keep us on track.  A book co-authored by Tetlock states: “What you think is much less important than how you think…Foresight isn’t a mysterious gift bestowed at birth. It is the product of particular ways of thinking, of gathering information, of updating beliefs.” The book’s overarching message: “Broadly speaking, superforecasting demands thinking that is open-minded, careful, curious, and— above all— self-critical.” In short, the characteristics of great achievers are the characteristics our energy-saving subconscious frequently drives us away from.

 

For perspective, take an example from the financial crises; a period when many people put their subconscious in the driver’s seat.  At the depths of the crises, many stopped investing precisely because the stock market was down,  others locked in severe losses and abandoned even well-reasoned investment strategies.

 

A Reuters article written just after the depths of the financial crises provides insight into the many investor attitudes at the time:

 

November 2010

 

Though the couple had been in and out of the market before, Chase, a 42-year-old part-time consultant and self-described conservative investor, said she has no intention of getting back in again.

 

“It makes me nuts when I get out early and there’s more money to be made, or I get out late when I could have made more if I’d gotten out early,” she said. “The stock market’s not an investment, it’s gambling.”

 

The faith -- and money -- individual investors once held in the stock market has severely eroded. Two painful major stock market crashes over the last decade combined with the advent of arcane, complicated trading practices has created widespread suspicion of Wall Street, which many people now regard as no better than a roulette table.....

 

As stocks began to stabilize in 2009, analysts predicted that the floods of retail money returning to the market would fuel a rally. That didn’t happen, but the market rose anyway.

 

What we know today is that many investors locked in losses, missed out on one of the greatest bull markets in history, or jumped back into the party after most of the fun had already been had. 

 

Thankfully, better decisions are within grasp of those humble enough to reach out. Daniel Goleman well summarized what to keep in mind:

 

“The range of what we think and do is limited by what we fail to notice. And because we fail to notice that we fail to notice there is little we can do to change until we notice how failing to notice shapes our thoughts and deeds.”

 

As investors, if we want to adopt the right mental filters we must go out of our way to notice what may sometimes feel unnecessary, wrong or even against our interest. No small task! It is not a coincidence the investors from the Reuters article picked a horrible time to conclude: “The stock market is not an investment, it’s a gamble.”

 

This viewpoint in the moment was likely influenced by biases such as loss aversion; a bias discussed in a separate blog post. Had these investors understood this bias and considered alternative viewpoints –  for example, many successful and well-reasoned investors argue that as the market goes lower it becomes less of a gamble, more of a durable investment opportunity – they may have chosen a more prosperous path. 

 

(Great books related to this topic include, The Undoing Project, The Little Book of Behavioral Investing, Your Money, Your Brain, The Book of Value, and Stumbling on Happiness.)

Rob Dainard