The Tricks Your Mind Plays On You
Our brains are complex, so the decisions we make aren’t always the right ones. Martin Hawes explains why.
18 October 2021
For the most part, investors are human.
Sure, there are computers which trade the markets, working off algorithms while they trade at high speed in big volumes, but most investors in the market are real, live people making decisions; sometime right, sometimes wrong.
This could be good. Except it turns out that humans have some basic wiring faults.
These flaws create foibles and quirks that hold back our ability to be perfectly rational investors.
Fight or flee
As a species, we grew up on the savannah with the idea that we needed food so, with danger all around, we needed to make lightning-fast decisions – fight or flee.
To be wired like this was excellent when we roamed the countryside, looking for something convenient to eat.
However, it turns out now that this wiring, so carefully planned and installed over millions of years to make our brains work in a certain way, is not so good when we want to sit at home or in an office deciding whether to buy Contact or Meridian, or, maybe, sell the Nasdaq.
The science of investing
People have become fascinated by the flaws that show up when our brains are applied to investing, rather than chasing down an antelope or getting out of the way of an elephant.
Over the past few decades, a whole new area of study has opened called behavioural economics.
In a nutshell, behavioural economics shows that we’re not always rational. We have ‘cognitive biases’ – emotions and social influences which drive our behaviour and mean that we don’t always make rational decisions. Here are some of them.
Let’s look at a behaviour I often see when someone buys an investment which turns out to be a dog and drops in value.
Let’s say they bought a share for $2 and it’s fallen to $1.20.
Many people won’t sell because they believe that by selling, they will have made a loss. This just isn’t sensible: in fact, they’ve already made the loss and the only question is what they should do about it.
People become ‘anchored’ to the price they paid and will only sell when it gets back to $2.
And so, instead of getting what’s left of their money out and getting it to work in something good, they hold on.
This flies in the face of rational thought: after all, the thing that lost you the money is unlikely to get it back for you.
Cutting your losses is sensible and rational – but it’s not what we always do.
There are plenty of ways we don’t use our rational brains to make decisions:
We rush in to buy overvalued shares because we fear that we’ll miss out (FOMO).
We feel there’s safety in numbers, so we follow everyone else as they rush into or out of the market.
We fail to invest, because we fear a loss twice as much as we appreciate a gain.
We follow our brother-in-law’s hot tip for the next great thing either because we’re greedy or we don’t want to look stupid for ignoring it.
We look at our portfolios three times a day, reacting to each little movement, rather than taking a 10-year overview.
How do you avoid bias?
It’s fiendishly difficult to recognise and override our biases and always behave rationally.
Here are a few that might ring true:
- We use rules of thumb.
- We invest in the housing market because we’re biased towards it, instead of diversifying more widely.
- We work in a bank, so we invest in banks.
- We chase winners, and judge by past performance. Actually, past performance is no indication of future performance.
- We treat a fallen share as a bargain, because we’re mentally anchored to the higher price of
- a week ago.
- We buy on the basis of tips and gossip, rather than on expert information.
- Perhaps worst of all, we exaggerate our talent and get overconfident.
These are all examples of our social and emotional selves getting in the way – and the cognitive biases that drive irrational behaviour.
Take a deep breath
To overcome them, we have to slow down a bit and force ourselves to reconsider.
This means you have to have a process for investment.
For example, spend some time writing down why someone is selling the company or property that you’re buying.
There are always pros and cons for every decision.
You should look at the deal from both sides and then make a slow and rational decision.
We have to dampen our optimism and take our time.
Sure, that will mean occasionally you lose some good deals. But missing out is always better than being knocked out.
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Informed Investor's content comes from sources that Informed Investor magazine considers accurate, but we do not guarantee its accuracy. Charts in Informed Investor are visually indicative, not exact. The content of Informed Investor is intended as general information only, and you use it at your own risk.