The end of 2018 provided a reminder that investment markets can be volatile. While a relatively normal part of the investment experience, dramatic market moves can sometimes produce understandable feelings of anxiety.

Rather than hear about someone’s predictions about what the Fed might do with interest rates or tariffs or who is going to win the Super Bowl (none of which is accurately predictable), we thought it might be more interesting to get some perspective on things within our control.

At this year’s Annual Outlook, our guest speaker was Ken Haman, Managing Director of AllianceBernstein. With more than 20 years of experience in psychology and human behavior, Ken provides a unique perspective on developing the skills of being a successful investor. In his work you will not find references to mathematical terms like Sharpe Ratio, Beta or Duration. Instead of spreadsheet processes, Ken tries to help us elevate our awareness of our emotional processes. At its root, investing is about addressing the emotional challenges that come from being vulnerable in a big and often frightening world. We worry: “Am I going to be okay?”, “Is my family going to be okay?”, “What steps do I need to take to protect myself?”

 

Thousands of years ago, humans answered that last question by gathering into groups, developing tools and weapons, cultivating fields, breeding livestock, building villages, and surrounding villages with walls. These advancements were driven by the desires to increase security and reduce risk.

Although civilization has advanced dramatically over the past 50,000 years, despite our achievements, our brain, central nervous system, and survival instincts essentially remain as they were back in the prehistoric era. The result is an odd contradiction in how we experience money and investing: our rational, educated and modern brain thinks one way while our emotional, instinctive and primitive brain can react very differently.

 

A BRAIN IN TWO PARTS: INVESTING IS MORE COMPLICATED THAN YOU MIGHT THINK

Over the millennia, the human brain evolves. The oldest, most primitive part is the brain stem, the structure that controls our instinctive fight-or-flight reaction. Its primary function revolves around survival. A newer section, the neo-cortex, has evolved to cope with more complex issues; rational thought, language, long-term planning and the ability to process a variety of information needed to understand a complex world.

This insight—the idea of “two brains”—is central to the challenge of investing. Investors perceive information and then, based on their personal experiences and interpretation, begin to react. If the information is benign or pleasurable, the central nervous system may decide there’s no need to take strong emotional action. However, when the information is negative or threatening, it can be a different story. Emotions can interrupt our ability to think rationally. Fortunately, science has revealed a way to become aware of these instinctive patterns.

HEURISTICS: AUTOMATIC WAYS OUR BRAIN TRIES TO MAKE DECISIONS EASIER

For all human beings, the dynamics of language, thoughts and emotions are deeply connected. Research has shown that sometimes the brain uses automatic-thinking mechanisms or shortcuts to process and react to information. These are called heuristics, and the study of how heuristics influence financial decision-making is the focus of the discipline known as behavioral finance.

 

Dr. Daniel Kahneman was among the first scientists to uncover patterns of thinking, many of which significantly influence how we make investment decisions. Most of these patterns result in decisions that feel natural and correct but cause us to make investment mistakes. One classic example is how we naturally distinguish between pain and pleasure. Kahneman discovered that we are more than twice as motivated to avoid pain as we are to seek pleasure. This means we feel pain from an investment loss significantly more than we get pleasure from a gain. Even though mathematically it would make more sense to see losses and gains as similar measurements, it feels to us like they are not. Kahneman called this heuristic loss aversion.

SOLVING THE OLDEST PROBLEMS: HEURISTICS STARTED OUT AS SURVIVAL TOOLS

 

Heuristics such as loss aversion originally worked very well. Because they are built-in patterns that get activated automatically, they enabled primitive humans to survive and prosper. Unfortunately, while they may work well enough in some situations, they typically work very poorly when applied to investment decisions.
When a leading economic indicator drops, it causes a similar feeling as the howl of a wolf. A short-term correction in an asset class is like the snarl of a saber-toothed tiger. The drop of a few basis points in a bond fund’s valuation seems like the movement of a crocodile on the edge of a riverbank. The problem isn’t so much that changes stimulate reactions; in many cases, we should react to changes in our environment. The real problem is the way we react. Our brains tend to respond to changes we experience today the way they did 50,000 years ago and use mental shortcuts that might not fit the current situation.

One of the shortcuts the human brain uses to cope with a complex environment is to simplify challenges.  For a survival-oriented brain, keeping things simple is very important. Unfortunately, when it comes to investing, it’s possible to make things too simple.

Because the primitive part of our brain likes to keep things simple, we sometimes lose track of our purpose when investing. We can fight this inclination by setting specific goals attached to a concrete vision of the future. Detailed mental images allow your brain to make rational sense of the investing process and keep emotions under control. With clear goals and a rational understanding, you can look at an investment that has lost money in the short term and say, “I’m still on track and I’m doing okay!”

This brings us full circle to the ultimate question: “Am I going to be okay?” This big question cannot be simplified to a single number or one simple indicator. It requires looking at how we cope with our built-in vulnerabilities: the concept of efficacy.

The Oxford English Dictionary defines efficacy as “the ability to produce a desired or intended result.” While the definition is short, the importance of efficacy cannot be underestimated. Each of us enters the world as a small, fragile and completely dependent creature. We spend years learning how our bodies work, how to interact with others and how to cope with challenges. As soon as we’ve mastered the basic skills for navigating the world, we become aware of our weaknesses and vulnerabilities.

As we age, life becomes more complicated and the consequences of failure become more serious. Efficacy is found in people who feel they can overcome adversity, protect themselves from dangers and produce their desired results; they’re confident they will be okay in the future.

Conversely, someone who lacks a self-concept of effectiveness or has little confidence sees the future as uncertain and frightening. The human without efficacy cannot confidently answer the question “Am I going to be okay?”. This has direct and significant implications for investing.

THE WEAKNESS OF 20/20 HINDSIGHT

Our brain tends to confuse looking back in time with being able to predict the future. Therefore, we often say “I should have known better” after we make a mistake. With the benefit of hindsight, the negative results
now appear to be obvious and inevitable. In his book Thinking, Fast and Slow, Daniel Kahneman provides guidance about 20/20 hindsight: “Hindsight bias has pernicious effects on the evaluations of decision makers. It leads observers to assess the quality of a decision not by whether the process was sound but by whether its outcome was good or bad.…This outcome bias makes it almost impossible to evaluate a decision properly—in terms of the beliefs that were reasonable when the decision was made.” 

 

 

A successful investment is especially tricky to think about; if it performs well, most investors are seduced by the thought that they made the right selection. Nassim Taleb confronts this idea directly in his book Fooled by Randomness: “Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).” The great investor is humble in the face of the conditions of uncertainty, complexity and urgency that define the challenge of investing.

SOCIAL PROOF IS “FOLLOW THE LEADER” FOR ADULTS

As we explore different types of heuristics, it becomes clear there are many ways for our brain to answer the wrong question. For thousands of years, decision-making often boiled down to asking, “What are other people doing?” If everyone was running away, it was probably smart to join them. If everyone was fishing or harvesting, that probably meant it was a good idea to do the same.

 

Social proof is another heuristic that causes us to assess the value of an investment by how popular it is with other investors. Like most heuristics, social proof feels right and natural to the human brain. Unfortunately, when it comes to investing, what everyone else is doing is rarely an indicator of a good investment opportunity. It can feel intuitively right and even compelling, but many things about investing are counterintuitive and difficult for the primitive part of our brain to process. Investing quite often requires contrarian thinking…
doing the opposite.

 

 

HIGHER-QUALITY DECISIONS?

There’s no cure for heuristics. These patterns have been built in to the human brain by 50,000 years of experiences. So, the question is not “How can I avoid making these mistakes?” You can’t; they’re built in to the way we think about the world and are helpful under certain circumstances. When it comes to investing, a better question is “What can I do to make higher-quality decisions?”

 

Pay attention to your feelings. Heuristics operate within the most primitive part of the brain: the part in charge of survival…the fight-or-flight instinct. When you are feeling emotional about a decision, that is a good indicator of a heuristic being activated. When investing, avoid succumbing to emotions and try to recognize that slow, rational thinking will likely lead to better long-term decisions.

A comprehensive discussion of Behavioral Finance is beyond the scope of this article. We are passionate about the topic and convinced that the mastery of emotions will have a far greater impact on long-term investment decisions than anything that can be found in a spreadsheet. We hope you enjoyed this introduction. Stay calm and invest on!  IIII