In our last piece, “ opens in a new window Investment 101: Part 10 – What Has Evidence-Based Investing Done for Me Lately?” we wrapped up our conversation about ways to employ stock and bond market factors within a disciplined investment strategy, as well as how to extract the diamonds of promising new evidence-based insights from the larger piles of misinformation. We turn now to the final and arguably most significant factor in your evidence-based investment strategy: the human factor. In short, your own impulsive reactions to market events can easily trump any other market challenges you face.
Despite everything we know about efficient capital markets and all the solid evidence available to guide our rational decisions … we’re still human. We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions – a brew of chemically generated instincts and emotions that spur us to leap long before we have time to look. Rapid reflexes often serve us well. Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running without pause to think; his or her laughter elicits an instant outpouring of love (and oxytocin). But in finance, where the coolest heads prevail, many of our base instincts cause more harm than good. If you don’t know that they’re happening or don’t manage them when they do, your brain signals can trick you into believing you’re making entirely rational decisions when you are in fact being overpowered by ill-placed, “survival of the fittest” reactions. Put another way by neurologist and financial theorist William J. Bernstein, MD, PhD, “Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.”
To study the relationships between our heads and our financial health, there is another field of evidence-based inquiry known as behavioral finance. What happens when we stir up that Petrie dish of financial pathogens? Wall Street Journal columnist Jason Zweig’s “Your Money and Your Brain” provides a good guided tour of the findings, describing both the behaviors themselves as well as what is happening inside our heads to generate them. To name a couple of the most obvious examples:
Beyond such market-timing instincts that lead you astray, your brain cooks up plenty of other insidious biases to overly influence your investment activities. To name a few, there’s confirmation bias, hindsight bias, recency, overconfidence, loss aversion, sunken costs and herd mentality.
Managing the human factor in investing is another way an evidence-based financial practitioner can add value. Zweig observes, “Neuroeconomics shows that you will get the best results when you harness your emotions, not when you strangle them.” By spotting when investors are falling prey to a behavioral bias, we can hold up an evidence-based mirror for them, so they can see it too. In our next piece, we’ll explore some of the more potent behavioral foibles investors face.