Being an investor is not easy. We must contend not only with the erratic and unpredictable nature of markets but also with the sometimes erratic and irrational ways in which we are tempted to think and behave. Today’s many and varied temptations include Bitcoin, the ‘Magnificent Seven’ tech stocks in the US, and gold. All are at our fingertips at the press of a button on our phones. As Benjamin Graham, one of the great investment minds of the twentieth century, famously stated (Graham and Dodd, 1996):

‘The investor’s chief problem – and even his worst enemy – is likely to be himself.’

Our brains take two approaches when making decisions: one is intuitive and emotional, and the other is logical and rational1. The former often uses ‘heuristics,’ i.e. mental shortcuts that are often approximate and, in the worst case, simply wrong. This is known as our ‘X’ (or reflexive) system. It is driven by the amygdala, an old, reptilian part of the brain that is, in an evolutionary sense, the centre focused on managing risk and fear, along with the nucleus accumbens, which is integral to greed and our desire for reward. The logical side of our brains – the ‘C’ system – provides rational, considered, evidence-based decisions, kicking in when the more intuitive side of our minds is floundering. It appears that our emotional decision-making has evolved to trump our logical thinking in many instances.

The problem we face is that we tend to use our intuitive decision-making process more often under a set of conditions that apply to the types of decisions we face as investors. These include complexity, incomplete and changing information, competing goals (e.g., preserving capital today by taking on little risk but risking failure to meet our long-term goals by not taking enough risk), when we are stressed, and when we need to make decisions that involve other people in the process (Montier, 2010).

Figure 1: Intuitive decision-making can be bad for your wealth

We tend to pay too much attention to recent market events, such as the rising price of gold and Bitcoin – known as recency bias – and driven by envy, or simply a fear of missing out (FOMO), we may get tempted. We may be overconfident in an ability to pick good investments and see patterns in the markets where none probably exist. Some are tempted to look at what has happened in the past and feel that this was predictable (hindsight bias), implying that forward-looking predictions are easy.

We also like to anchor ourselves to specific numbers. For example, imagine that equities have doubled over the past ten years, yet in the past few months, they have fallen back by 15%. Many investors will feel disappointed that they ‘lost’ money because they have anchored on the high point, even though over the period, they have doubled their money. Anchoring on the starting point would be a much better strategy, rejoicing in the total gains made. Familiarity, e.g., with well-known companies in one’s home market, can lead to investment decisions that are not based on evidence and theory but on emotion. Even today, some investors hold a material bias to the UK stock market, even though the companies that comprise it only represent around 4% of global equity market capitalisation.

 

So, what can we do?

The key to curbing the reptilian-driven thinking system and firing up the logical and rational part of our brain, is to give it the time and space to reflect on the challenge at hand. A good starting point is to ask yourself – perhaps in conjunction with your financial planner – a few questions. If you really want to turn on your logical ‘C’ system, then write down your questions and your answers. If you have the urge to act on your portfolio, ask yourself the following:

• Are you being influenced by recent events, such as good/bad market or fund performance? Does this go against the investment approach that you have previously bought into?
• Do you think that you have some form of insight into the investment decision that other bright and dedicated investors do not? Remember that most professional managers fail to beat the market!
• Is your decision based on some sort of trend you see, e.g., the gold price going up? The trend is not your friend – it is probably meaningless.
• Are you under the illusion that investing is easy, as what just happened was ‘obvious’ looking back at it?
• If so, are you tempted into making predictions about the future? If so, polish your crystal ball, wave your rabbit’s foot, and cross all fingers and toes. It is well-nigh impossible as markets do a pretty good job of reflecting information into current prices.
• Are you being swayed by the familiar? Do you know the company, industry, or markets better than other possible options? Be careful of familiarity bias.
• Are you very excited by the trade-off between the returns promised and the risks you are taking? If so, look hard, as these opportunities are rare. It is probably just that you have not fully uncovered the risks that you will be taking.

At the end of the day, the poor decisions that we make based on our emotions and driven by the biases we all suffer result in less money in our retirement (or other) investment pots, which will have lifestyle consequences down the line. By heeding these simple bits of advice, we can at least buy ourselves a little time to allow our reflective, logical brains to kick in and control the narrative, wrestling it away from our intuitive reptilian brains. Stick with your investment process and avoid temptation.

 

General Investment Risk Warnings

Please remember the value of your investments and any income from them can go down as well as up and you may get back less than the amount you originally invested. All investments carry an element of risk which may differ significantly.

If you are unsure as to the suitability of any particular investment or product, you should seek professional financial advice. Tax rules may change in the future and taxation will depend on your personal circumstances. Charges may be subject to change in the future.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Portfolio performance data are for illustrative, educational purposes only and do not represent live client portfolios.