A Tale of Behavioral Instincts
As investors, we are consistently at odds with our pre-programmed human behavior. That is, our basic-survival instincts often play against otherwise well-reasoned financial decisions. As such, the market may favor those who are better at overcoming their impulsive, often damaging gut reactions to breaking news. Once we complete our exploration of market return factors, we’ll explore the fascinating field of behavioral finance in more detail, as this “human factor” contributes significantly to your ultimate success or failure as an evidence-based investor.
In our last piece, “Investing Seeking the Future” we wrapped up our conversation about ways to employ stock and bond markets within a disciplined investment strategy. We now turn to the final and arguably most significant factor in an evidence-based investment strategy: the human factor. In short, impulsive/ behavioral reactions to market events can easily outweigh any other market challenges you face.
Exploring the Human Factor
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.”
Behavioral Finance, Human Finance
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:
- When markets tumble – Your brain’s amygdala floods your bloodstream with corticosterone. Fear clutches at your stomach and every instinct points the needle to “Sell!”
- When markets unexpectedly soar – Your brain’s reflexive nucleus accumbens fires up within the nether regions of your frontal lobe. Greed grabs you by the collar, convincing you that you had best act soon if you want to seize the day. “Buy!”
An Advisor’s Greatest Role: Managing the Human Factor
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 approach helps to guide us- using data driven methodology instead of emotion. By spotting when we (as investors) are falling prey to a behavioral bias, it is possible to overcome emotional decision making and implement a strategy based on rational observations.
Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina. Contact us to learn more about our services.
Image Attribution: Carl Richards (c) 2013 Behavior Gap