Is Your Brain Hardwired to Sabotage Your Investments?
10 minute read
Sir John Templeton is famous in the world of investing. John died back in 2008, but in his life he was the founder of a company called Templeton Investments. One of his most famous quotes is: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
Before we get into this blog, let’s first define what is meant by a bull market or a bear market? The exact origin of these terms as they are applied to the stock market is unclear, but their use today can be easily understood. A bear market refers price declines of 20% or more, in either a single security or a market in general. A bull market refers to the opposite, prices rising 20% or more.
The recent months of 2020 have certainly been a microcosm of what Sir Templeton was speaking to. As recently as February 19 the US markets were at all-time highs. This was the completion of an 11 year run where stocks, as measured by the S&P 500, went up 401%. Euphoria was apparent everywhere.
In a mere 30 days or so the outbreak of COVID-19 brought an end to one of the longest bull markets in US history. In so doing, it also ushered in the onset of one of the quickest bear market declines in history. By March 23, the S&P 500 was down 33% from the February high. The euphoria of the bull market was replaced by rampant pessimism and maybe even depression (for some). However, according to John Templeton, it is in that pessimism that a new bull market is born.
As you can see in the above graphic, the point of maximum risk occurs when investors are feeling euphoric and the point of maximum opportunity usually coincides with feelings of pessimism, despondency and even depression.
All of this speaks to the way our human brain is wired. Behavioral Finance is an entire field of study that focuses on how our emotions and internal biases impact our financial decisions.
 Source: JP Morgan Asset Management Guide to the Markets – U.S. Data https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets/viewer
Over thousands of years of evolution our brains became hardwired for survival. We are wired with instincts like “fight or flight” and “herding”. Fight or flight refers to the decision to either run from danger or stand there and fight knowing we could die. Herding is the act of following the crowd. In more primitive days, people would congregate in groups or tribes for safety. We still have that tendency today.
While our brains are wired by strong instincts designed to help us survive in a world of dangerous animals, this wiring doesn’t work as well when it comes to stock market investing. Because of our herding nature, we investors are often referred to as “lemmings” by the financial media. Lemmings are little creatures that follow the leader; even when the leader jumps off a cliff.
Often success in the markets requires the opposite of herding. We need to resist the urge to follow other investors who “buy high and sell low”. Think of it like this: if you are afraid to look at your investment statement, chances are most other investors are as well. This collective fear leads many people to sell their investments as a survival instinct. As we said earlier, we are a herding species, we all tend to make these instinctual decisions around the same time. As the chart on the previous page demonstrates, this is often the point of maximum opportunity. Many times our office receives calls from clients wanting to sell at the absolute bottom of a market downturn. Doing the opposite of the crowd, or our internal instincts, may be a good choice in certain investment situations.
Warren Buffett put it this way: “I like to be greedy when others are fearful and fearful when others are greedy”. In looking at our chart on the previous page, we see that the point of maximum risk is when most investors are in a state of euphoria. As Mr. Buffett said, he likes to be fearful (a seller of stocks) at those times. And when most investors are fearful? That is when Mr. Buffett likes to buy or, as he puts it, be greedy and buy as much stock as he can.
So how do we circumvent our internal hard wiring to become better investors?
Rule #1 Become self-aware
Psychologists tell us that we all have biases. Biases are a predisposition to think and act a certain way, which we are usually unaware of. Do a “self-inventory” and honestly look at your biases. Discover and discuss them with an advisor who has training in this area of Behavioral Finance. Build a plan to deal with your biases. If you don’t take this step you may make very costly decisions over the years.
Here are some of the most common biases affecting investors…
Confirmation Bias: looking for articles and research that confirm your current view of a stock or the stock market while ignoring opinions or research that contradict or challenge your preconceived notions.
Endowment Bias: thinking something you own – like a stock or real estate – is worth more than the market is willing to pay.
Anchoring: the tendency to favor the first bit of information we learn and discounting information that comes later.
Recency Bias: this is the tendency to think that what has happened recently will continue indefinitely – like a bull or bear market.
Loss-aversion bias: a tendency to prefer avoiding losses over acquiring equivalent gains.
There are many more biases, and we all have some of them. CWM Bias Worksheet .pdfClick here to download our self-evaluation form to see what biases you may have. If you think that you don’t exhibit any bias, you’re probably suffering from “self-serving bias”. Yes, that’s actually on the list.
Even financial advisors have biases. As you discuss this with them, be sure to ask how he or she manages their own biases. This will offer clues about whether this person has actually dealt with themselves. If they don’t have good answers or worse, don’t know what you’re talking about, this could lead to unpleasant surprises down the road.
Rule #2 Use a Goals-Based Investment Strategy
The average investor is familiar with the major indices: the S&P 500 and the Dow Jones Industrial Index. These indices measure the broad performance of the stock market and data is easy to locate, often on the evening news. Are these indices the right benchmark for your investments?
Investors may improperly measure their success by what they see reported about the Dow Jones Industrial Average. However, it is important to realize that Indices don’t have goals like you do; they aren’t paying for college or generating income in retirement. What is a better way to know if your portfolio is working properly for you?
Some investors like to compartmentalize their investments into several “buckets” (see picture on next page). One bucket is for safety and should be thought of as an emergency fund which should utilize low or no volatility investments such as a savings account or a CD. A second bucket is for income, generating part of your monthly income needs via bond interest or dividends from a blue chip stock portfolio. Third is a growth bucket; investments that help beat inflation and have a long term time horizon. In some cases, money can be moved each year from the growth bucket to the safer buckets to replenish money that has been used.
A specific behavioral bias to watch out for when using the bucket strategy is known as mental accounting.
Mental Accounting refers to a tendency to think of some of your money for one purpose and other money for another purpose. For example, you may have accounts with different financial advisors and thus view each of those accounts as earmarked for a specific savings goal or income needs.
The potential pitfall here is that you stop looking at your portfolio as a whole and may lack a comprehensive game plan or cohesive goals.
When you use mental accounting, and start to mentally earmark your funds, it can become difficult to evaluate the performance of your investments.
Rule #3 Develop and commit to rules that govern your investment decisions
Work with an advisor who utilizes a rules-based approach to investment decisions. Discuss the rules and how they are applied well in advance of any new investments. This is important because advisors have biases just like everyone else. If you don’t have agreed upon rules, you and your advisor may agree to make the wrong move at the wrong time based on emotions and fear. There is no one right answer to which rules to apply. As the quote below states, there are many disciplines that work well over time.
“The reason Warren Buffett is successful is not because he has a magic stock wand, but rather has unbelievable ability to stick to his style. There are numerous investment styles on Wall Street that work - value, momentum, trend, buy and hold - they all work. The challenge is sticking to your style and not selling at the worst time".
--Meb Faber, co-founder Cambria Investment Management
Once you find an advisor with whom you are comfortable and he/she utilizes a rules-based investment process, stick with the process! If the process is well thought out, resist the temptation to abandon it because there is a good chance you will act at the wrong time.
As Socrates once said, “To know thyself is the beginning of wisdom”. Nowhere is this truer than the investment markets. Talk to a trained behavioral advisor and identify the investment biases that lead to the destruction of your capital.
Due to our internal biases, we investors are often our own worst enemies. As financial author Nick Murray once said, “Human nature is always and everywhere a failed investor, the traits of investment success are simply not available to the unaided human mind… The key to outperforming other people is simply behaving more appropriately than they do – this is the beginning of wisdom.”
Our team is here to help. We are trained in Behavioral Finance and our goal is to create better investors through education, advocacy and mentoring. Feel free to reach out if you would like to talk. We would love to help.
Securities offered through IFP Securities, LLC, d/b/a Independent Financial Partners (IFP), member FINRA/SIPC. Investment advice offered through IFP Advisors, LLC, d/b/a Independent Financial Partners (IFP), a Registered Investment Adviser. IFP and Callesen Wealth Management are not affiliated. Past performance is no guarantee of future returns. Investors cannot invest directly in an index. Diversification and asset allocation do not guarantee returns or protect against losses. The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and it advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.