HOW YOUR BRAIN LETS YOU DOWN
Roy Davidson, 12 January 2021
In periods of turmoil and change, we tend to fall back on our instincts. However, these were shaped hundreds of thousands of years ago in a world unrecognisable from the present day. While our instincts served our ancestors well, they can sometimes lead us astray. In this article we discuss some common investing biases and what you can do to counter them and be a better investor.
A product of our evolution
We are not perfect logicians. Our brains evolved to help our ancestors roaming the plains of Africa find food and avoid predators. They were not designed for us sitting behind computers deciding how to invest for our future. While our brains are virtually unchanged, the world has changed beyond recognition – share markets themselves are only 400 years old. We’re essentially running the latest operating system on outdated hardware.
The world has changed exponentially, but our brains have stayed the same
There is no ‘Homo economicus’
Any economics student will have studied models that assume humans behave perfectly rationally all the time, making choices that optimise their own welfare. This perfectly rational and self-centred being is commonly termed Homo economicus.
However, there’s a problem - this creature doesn’t exist. It turns out that people have built-in behavioural biases that influence their decision making and assessment of risk. It also seems that most of these are shared by our closest primate relatives. In study after study, apes and monkeys are shown to fall victim to the same biases and mental shortcuts that affect us.
Knowing how your emotions might be influencing your decisions is a powerful piece of knowledge for an investor to have. With this in mind, you’ll be less likely to make poor decisions. And by following some simple rules which we’ll discuss later, you’ll have a better chance of generating good returns over a sustained period of time.
Biases that affect us all
Homo sapiens means ‘wise ape’. However, in many cases, we don’t live up to our name. There are some common behavioural biases and mental shortcuts that affect us all from time to time, whether you know it or not. All of these are deeply rooted in the instincts that served our ancestors so well, but can let us down in the present day.
1. Bandwagon effect
Going along with the crowd is a decent survival strategy – there’s no point rushing towards danger while everyone else runs away. However, it can lead you astray.
This behaviour is often seen during bubbles where investors jump on the bandwagon just because everybody else is doing it, despite not really understanding what they are investing in. The fear of missing out (or FOMO) can be a powerful emotion.
Good investors are able to think independently and put things into perspective even though it can feel somewhat uncomfortable at the time.
2. Loss aversion
We tend to feel more pain from a loss than pleasure from an equivalent gain. Think about it – the loss of a day’s food could have spelled death while the gain of a day’s food would’ve been unlikely to have upside of the same magnitude.
How this plays out today is that an investor might be more reluctant to sell shares that have fallen and have a deteriorating outlook, than those that have risen and have a positive outlook, as the pain from the loss will be felt much more acutely.
This can result in an investor holding on to shares that have fallen in price in the hope of some-day making their money back. However, if your money is better off being invested somewhere else, then you should sell your shares and put your money to work elsewhere.
3. Recency bias
Also hardwired into our brains is that we tend to recall more prominently events that have happened in the recent past, over those that happened some time ago. Recent events, say the appearance of a lion at a nearby watering hole, were typically more relevant for survival than those that occurred long ago.
This creates issues for us today. For example, a poor result or short-term issues from an otherwise high-quality company can cause investors to become overly pessimistic, creating a good buying opportunity for patient investors. Or, vice versa, investors may extrapolate good recent performance from a lower quality company far into the future when this is unlikely to be the case. Don’t make decisions based on current headlines.
4. Confirmation bias
We have a natural tendency to place more weight on information that agrees with our view, and less on those that don’t. In fact, hearing an opposing view can make us even more entrenched in our own view. Just as this can result in an unbalanced world view, it can also result in an unbalanced view of a company’s prospects.
An investor with their ‘blinkers on’ can potentially misjudge the risk/reward proposition of a company and be caught unaware should things take a turn for the worst. Keeping an open mind and admitting you might, in fact, be wrong, are some of the best disciplines an investor can have.
5. Anchoring bias
This is where investors rely too heavily on one particular piece of information, often the recent share price of a company, and base decisions around this.
In practice, this may cause an investor to base their buying or selling decisions on where a company’s share price has traded in the past, even though this provides little information as to whether shares are under or over-valued. A stock may have increased in price recently for very good reason, or, conversely, fallen deservedly. What matters is the outlook at the present time, regardless of the recent share price or the price you historically paid.
So, what can we do about it?
Behavioural biases, like it or not, affect all of us. Being aware of when your decision making may be being influenced by one or more of these biases is a great first step.
By and large, the best thing you can do is focus on what you can control and try to take the emotion out of it as much as possible. Have a plan and stick to it. This way, if markets do take a turn for the worst, you can fall back on the fact that you have a plan, are invested appropriately, and not get caught up in the panic. In fact, you might be able to view it as an opportunity.
Nobody knows everything. Sometimes you have a very strong view on something and may be tempted to go ‘all-in’. But one of the best things you can do as an investor is admit that you (or anyone else for that matter) don’t know it all, and that maybe, just maybe, things might play out in a way that you didn’t imagine. This is where diversification plays a crucial role. Spreading your investments across a number of investments is one of the best things you can do to manage risk and help you to meet your investment goals.
Of course, we’re not going to get everything right. This is a natural part of investing, but we need to accept this and be prepared to cut those that haven’t quite worked out from time to time, even if this means selling at a loss.
Finally, don’t forget, time is your friend. Establishing a portfolio of high-quality companies and holding them for the long-term will give you the best chance of succeeding even though the market will likely experience many ups and downs along the way. So long as you know what you’re trying to achieve with your portfolio (let’s say building a nest egg for many years down the track), you’ll be able to ride the ups and downs with the knowledge that this is to be expected and that the end destination is unchanged.
This is an excerpt of an article first published in the December 2020 edition of News & Views. Craigs Investment Partners clients can view the latest edition of News & Views, which includes the full version of this article, by logging in to the Client Portal.