Instincts are part of being human. Whether helpful or not, our instincts creep their way into our daily decision-making process. Unfortunately, investing decisions are no different. Why “unfortunate”? Our instincts often work against us in investing. You may hear your peers mention they just “knew” Equity X would fall 15%. We hear these stories all the time when instincts led us to make the right decision. Or we “knew” something bad would happen and we made a mistake by not listening to our instincts. At least that’s how we remember it. However, these beliefs are almost always tricks your brain is playing on you.
Behavioural finance is a school of behavioural psychology dedicated to understanding how our brain has evolved in the way we make day-to-day decisions. Financial professionals use behavioural finance to understand what causes investors to make investing mistakes. Maybe unsurprisingly, brains that were well-suited to survival in past millennia aren’t as well-suited to process the more modern institution of investing. In fact, if there is anything that we have learned from behavioural finance, it’s that you should keep instincts out of investing decisions.
Our Selective Memory Blinds Us
Our brains are not constructed to deal well with complex systems like equity markets. How can our instincts lead us astray? Ask your peer who just “knew” Equity X would fall 15% if they actually knew it would drop or if it was a passing thought that built up more conviction as the equity’s price started falling. Whether they want to admit or not, many times it’s the latter. This is also known as the “hindsight bias”—the feeling after the fact that you “knew all along” the outcome would occur, even if you really only had a vague suspicion. This false belief feeds confidence in your instincts, which could lead you to fall prey to your behavioural biases again and again and detract you investing successfully. A tendency toward overconfidence is natural. We are only human and admitting when we are wrong can be difficult. It feels much better when we get to boast about being correct! You may hear from a friend something like, “if you just bought the three equities I told you about, you would be outperforming the market.” What that friend forgets to mention is the other 10 equities they suggested that are not doing as well. It’s not all their fault! Overconfidence is one of the mean tricks our brain plays on us to blind us from reality.
In market research our firm conducted with investors who manage their own investments, we documented a large number of investors who “knew” the 2008 bear market would go the way it did. They stated the downturn was obvious to anyone with a bit of common sense. In reality, if these investors really knew what was going to unfold in 2008, they would have got out of the market rather than suffering enormous losses, as many people did.
People Dislike Losses More Than They Enjoy Gains
A study conducted on American investors showed that they dislike losses 2.5 times as much as they enjoy the pleasure of gains.[i] Whilst this may be hard to believe, you can thank our earliest ancestors for hardwiring this reaction into our brains. This response dates back to our ancestors looking to avoid immediate pain or injury. Those that best avoided injury were rewarded with survival, so it makes sense that our brains would naturally seek to avoid pain more than they seek to feel pleasure. Whilst the situations our ancestors faced may have more often been life or death, investors today may have a similar response to avoiding pain. This concept is known as myopic loss aversion.
In our view, investors know they should focus on longer-term goals rather than short-term moves in the market. But as volatility increases, investors may panic and their flight instincts start to kick in. They feel the need to take action and protect themselves from the near-term danger they face—separating them from their long-term strategy. Thanks to myopic loss aversion, investors are often willing to do this and this can mean losing out on greater returns in the future. Because we’re all human, we often feel the need to take action when we are faced with danger, failing to realise often the best action in investing is to do nothing at all.
Our Brain Acts Differently Under Pressure
Volatility can be considered the “price you pay” for equity-like returns. Corrections are a prime example of volatility. These are sharp, sentiment-based drops in the market of about 10% to 20% during a bull market. Even in years where the market is up a lot, the market rarely moves up in a straight line. Exhibit 1 highlights the corrections in the current bull market.
Exhibit 1: Current Bull Market
Source: FactSet, as of 2/1/2019. MSCI World Price Return Level from 9/3/2009 – 31/12/2018. Returns presented in GBP. Currency fluctuations between the pound and DKK may result in higher or lower investment returns. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of 23 developed countries.
Since corrections move on sentiment rather than fundamentals, it’s normal for markets to recover quickly, as sentiment can warm just as quickly as it cools. For some seasoned investors, it can be difficult to ignore the negative headlines that come with a market correction. Their instincts may tell them: “I need to stop the bleeding.” Investors who were able to ignore their instincts and stay invested throughout the correction are normally rewarded for doing so when markets recover. However, those who panicked and sold their equities are left trying to determine the right time to get back in the market—a difficult task.
Not even the most successful investors have consistently and accurately timed the beginning and end of corrections. Rather than trying to avoid every bump and bruise that comes with investing in equities, you should focus on what matters the most—your long-term investment goals. So if you do listen to your instincts and sell out of equities at relative market lows, you cost yourself future gains, whilst paying additional transaction costs. This sets you further back from meeting your investment goals.
Next time your instincts are trying to dictate an investment decision, remember: Whilst our brains have developed over time, the same reactions that governed our ancestor’s decisions are present in our investing decisions today, and they often hurt more than help.
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[i] Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica, Volume 47, Number 2 (March 1979). Pp. 263 – 291.