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Are you hurting your own investment success?

Why your basic instincts may be your biggest roadblock

Feb 1, 2013

by Max Fawcett

Of all the remarkable things we have achieved as a species over the last few millennia – democracy, indoor plumbing, the gin and tonic – there might not be anything more impressive than the development of our brains. Their ability to adapt, their capacity for creativity and imagination and their sheer intellectual firepower is the wellspring of our greatest accomplishments (and, regrettably, our vilest evils) and the primary reason – well, that and opposable thumbs – that we’re the ones posting videos of cats on the Internet and not the other way around.

But when it comes to investing, you might as well have Gatorade sloshing around in your head for all the good your brain does you. In fact, for all the talk about the economic death spiral in Europe, the eventual insolvency of the U.S. or the imminent inflation that will be the byproduct of years of central bank intervention, the biggest threat to your portfolio might be the grey matter between your ears.

A report released in late November by the Bank of Montreal more or less confirmed that. Notwithstanding the fact that a big bank has an obvious interest in reminding Canadians about their feckless ways with their money (thereby encouraging them to make use of BMO’s services), the numbers in the study are shocking. Two in five people said emotions play a role in their investing decisions, with anticipation, fear and trust the ones most often cited by respondents.

And when we’re not being guided by our emotions, we’re relying on either incomplete or non-existent information. According to the BMO study, “only 16 per cent are very familiar with the actual investments they hold in their portfolios,” while “only one-quarter do careful and extensive research before making investment decisions.” According to Serge Pépin, the vice-president of investment strategy at BMO Asset Management, “We spend more time researching computers and gadgets and cars and other consumer goods that we want to purchase.”

None of this comes as a surprise to Barry Ritholtz, a former Wall Street trader and the CEO and director of equity research at Fusion IQ, an online quantitative research firm. “Investing is really hard, and it’s really challenging,” he says. “But people tend to be their own worst enemy. The amount of self-inflicted damage is quite substantial.”

Prisoners of Instinct

One of the byproducts of the progress we’ve made as a species over the last few eons is that we have, from an evolutionary perspective, gotten ahead of ourselves. While we’ve learned how to work in offices and trade peaceably with neighbours, our instincts haven’t quite caught up yet.

Daniel Kahneman, an emeritus professor of psychology at Princeton and the 2002 Nobel Prize winner in Economics, has written extensively about the conflict between how we think and how we invest. The way we process information, solve problems and make choices is still geared, whether we know it or not, towards our chance of survival and minimizing the time and effort expended in the process.

Take our fight-or-flight instinct, that combination of adrenalin, alertness and fear that floods our bodies when we face a perceived threat, physical or otherwise. In the wild, it was a tool that helped ensure our genes got passed forward and not somebody else’s. But when it comes to more modern threats – say, reacting to a major decline in the Toronto Stock Exchange index – it can be that reaction itself that is the biggest threat of all.

After all, the time to buy (as Warren Buffett famously said) is when there’s “blood in the streets.” But what do most of us do when the blood starts to flow? We run. We panic. We sell. We behave, in other words, exactly the way our instincts tell us to. “If you look at how people respond to gains and losses,” Ritholtz says, “it’s pure id.”

And while passive investing has become popular in recent years, its adherents are just as vulnerable to the fight-flight reaction. “It wasn’t just stocks that were being sold in 2009,” Ritholtz says. “There were ETFs sold then as well. Lots of people just said ‘I can’t take the pain, I can’t sleep at night, I gotta sell.’”

Slaves to Non-existent Patterns

Back in the day – way, way back – the ability to identify patterns in a series of data points could mean the difference between having lunch and being it. And because the cost of seeing patterns where none existed was far lower (embarrassment and frustration, mostly) than the price of failing to pick up on one (death), we evolved to be hyper-vigilant in our search for meaning and order.

But like the cerebral equivalent of the appendix, that inclination has outlived its usefulness, and it has left us searching for coherence in a world usually defined by randomness. ”We have this terrible tendency to see pattern where perhaps none is there at all,” Ritholtz says, “whether it’s looking at a chart and seeing something magical or listening to someone on television making picks.”

A quick tour around just about any financial website will reveal all kinds of theories about the predictability of market behaviour, from ones that link market performance to the time of year to others that try to explain it using electoral cycles. In every case, the results are at best unsatisfactory – if they worked, the people pushing them wouldn’t need to be prowling around Internet message boards spreading their version of the gospel.

Indeed, as Professor Kahneman said in a recent interview with Der Spiegel, the fact that people still listen to stock pickers is clear evidence of our instinctive drive to find order in chaos. “Anyone who wants to invest money is better off choosing index funds, which simply follow a certain stock index without any intervention of gifted stock pickers,” he said. “Year after year, they perform better than 80 per cent of the investment funds managed by highly paid specialists.”

We’re Suckers for a Good Story

Monkeys love a narrative, Ritholtz says. “For most of human history, there was no movable type, no written language – it was very much an oral tradition,” he says. “So we’ve evolved to tell stories and to pass information along in a narrative format. That means investors love a good story.”

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The problem, he says, is that we often let the story determine how we look at the facts, rather than the other way around. An example of that, he says, is the way Wall Street greeted the arrival of the iPod in the 1990s. Back then, Steve Jobs wasn’t viewed as a near-deity and his company was more of an afterthought than the secular cult it’s become. Because all his colleagues had seen the rise and fall of the company, and because they weren’t Mac users themselves, he says, they thought they already knew what the company’s story was. They were wrong.

Ritholtz thought the iPod was an interesting innovation, and given that the stock was trading at $15 at the time with approximately $13 per share in cash, he thought Apple shares were a compelling investment. He made his case in a research note, passed it around to his colleagues in the office, and was greeted with nothing but skepticism. “All they knew was that Apple was a bad company that had mediocre earnings results and had done poorly in the past few quarters,” he says. “There was no recognition that there was a potential sea change here. You couldn’t get anyone to buy it 10 years ago. Over the past two years, you couldn’t get anyone to sell it.”

The good news is the facts are always out there on a given company, whether it’s a success in the making like Apple or a disaster waiting to happen like Kodak. But the bad news is we’re not inclined to pay much attention to them.

We’re Irrationally Fearful of Losses

Cut your losers short and let your winners run. It’s a fundamental piece of investment advice and yet one of the hardest for investors to follow. Instead, most do precisely the opposite. Why? Because our brains, thanks to millions of years of survival-of-the-fittest outcomes, are now hard-wired to fear losses in much greater proportions than we enjoy gains.

It’s an instinct we all share, and one that behavioural psychologists have studied at length. In a 2002 paper, economics professors Charles Holt and Susan Laury demonstrated that even when it came to a choice involving relatively puny stakes, people instinctively choose the least risky option. They ran participants through a series of exercises in which they were asked to choose between hypothetical paired lottery choices (for example, they would choose between one option that offered a 1/10 chance of winning $2.00 and a 9/10 chance of winning $1.60 and a second option that offered a 1/10 chance of winning $3.85 and a 9/10 chance of winning $0.10). The results were – and are – striking. “Even at the low payoff level, when all prizes are below $4.00, about two-thirds of the subjects exhibit risk aversion,” they wrote. Those were the theoretical choices, too. When they introduced real choices that involved real money, the behaviour intensified dramatically. “With real payoffs, risk aversion increases sharply when payoffs are scaled up by factors of 20, 50 and 90.”

We’re Bad at Processing Information

Most people imagine their brains are like a biochemical librarian that takes new information and interprets, organizes and stores it as accurately as possible. Unfortunately, the truth of the matter is that when it comes to dealing with new information, our brains are more like our crazy Uncle Pete who still insists that September 11 was an inside job.

Instead of taking new information at face value, our brains process it through a jumble of biases, bad habits and intellectual shortcuts. The so-called recency bias, for example, encourages us to prioritize information that’s new over that which isn’t, a habit that isn’t helpful when trying to understand the movement of markets. “When we’re watching a bull market run along, it’s understandable that people forget about the cycles where it didn’t,” certified financial planner and author Carl Richards told the New York Times last February. “As far as recent memory tells us, the market should keep going up, so we keep buying, and then it doesn’t. And unless we’ve prepared for that moment, we’re shocked and wondered how we missed the bubble.”

That’s not the only bad habit we have to contend with. “We even have selective retention,” Ritholtz says. “We remember things that agree with us and forget about things that disagree with us. And, in fact, we have such a confirmation bias, we go out and hunt down information that agrees with our views.”

We’re Overconfident

If there’s a story we’re particularly susceptible to, it’s one about our own superiority in a given area of activity. Terrance Odean, a finance professor at the University of California Berkeley’s Haas School of Business, tries to drive this point home to his MBA students every year by asking them to rate their driving skills. “Above average,” is the nearly unanimous answer every time he runs the test.

That’s a logical impossibility, of course – if everyone was above average, they’d be, well, average – but it speaks to our tendency to give ourselves a bit more credit than we might deserve. Indeed, Ritholtz says, the act of investing in stocks and bonds is a form of massive – and occasionally dangerous – overconfidence. “Nobody would think of getting up and playing football with the Dallas Cowboys,” he says. “They’d need three different stretchers to take your body parts off the field. But nobody hesitates to go up against the biggest, fastest and toughest hedge funds and trading shops.”

That’s why Ritholtz doesn’t think that most people should be engaged in stock picking.

Instead, like a lot of market watchers these days, he suggests a more passive approach – buy the indexes, invest regularly and avoid excessive trading and the return-killing fees that incurs. But as Reuters columnist Felix Salmon pointed out in a November 2012 piece, maybe that’s not the right way to look at investing – or, at least, our inclination towards doing it badly. Stock picking, he said, “is best analyzed as an upper-middle-class hobby rather than as purely profit-focused investing activity. Once you start looking at it that way, suddenly a lot of behaviour, which looks irrational under most lights, starts making a lot of sense.”

Investor, Know Thyself

The bad news about all this is that it’s difficult to eliminate these biologically informed biases and bad habits. There aren’t any shortcuts, either, no prescription pills you can take or 12-step plans to rid yourself of these demons. Some advisors have suggested that investors pre-commit to a course of action, perhaps with the certainty of a written contract, and thereby prevent themselves from changing their minds in a fit of market-induced panic.

Ritholtz rejects that approach, though. Instead, he says it’s all about knowing yourself better and understanding how you’ll react when things get ugly. “The reality is it’s a baptism by fire. It’s like going to war – if you don’t know what the actual live-fire exercises are like, if you don’t have the ability to anticipate that, you can’t really judge.” Once you’ve been through that, you’ll know what your weaknesses are and can plan accordingly.

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