How our brains lose us money
History shows that investors tend to do the opposite of what works.
Prior to the Global Financial Crisis, when stocks were expensive, everyone was piling in. After the crash, when they were cheap, they were selling (which is of course why stocks were cheap). That pattern is repeated throughout history. As much as we might recognise it, somehow it never changes.
It’s odd, when you think about it. In every other area of our lives we tend to buy more of something when prices fall and less when they rise. Why is investing - especially investing in the sharemarket - different?
Research house Dalbar’s long-standing Quantitative Analysis of Investor Behavior research shows that investors continually fail to beat the market, a proposition supported by other studies, including The Behavior of Individual Investors by Brad Barber of the University of California and Trading is Hazardous to Your Wealth by Barber and Odean.
None of this should surprise us. Ben Graham, known as the founder of modern investing, once said, “The investor’s chief problem – and even his worst enemy – is likely to be himself”. Behavioural economics, which applies psychological insights to human behaviour to explain economic decision-making, explains why that’s the case.
Why investors fail to beat the index
Since the 1960s, some of the best and brightest minds of our time, including William Goetzman, Robert Schiller, Ward Edwards, Amos Tversky and Daniel Kahneman, undertook research that revealed the irrationality in our decision making. This is the reason why so many investors fail to beat the index.
- First, we’re over-confident, with an inherent inability to acknowledge the full extent of our ignorance and the range of possible outcomes of a decision. This means we tend to pay high prices for stocks, especially those with rising share prices. Then, when reality intervenes and share prices fall, that optimism turns to fear and we sell out at the worst possible time.
- Secondly, this tendency is exacerbated by our herd instincts. To take advantage of cheap prices and avoid high priced assets inevitably involves going against the crowd, and that’s something humans find challenging. We like safety in numbers. But in investing, that tendency can bring us undone.
To overcome, it requires deeper information than most retail investors are prepared to dig up, and a mental approach driven by rational, probabilistic thinking, rather than the emotionally-driven decision-making unwittingly employed by many investors. And that’s far easier to say than it is to do.
We also have what Kahneman and Tversky called a bias towards loss aversion: we much prefer to avoid losses than acquire gains, which is why so many of us sell out when a share price or unit price in a managed fund falls, meaning we miss out on the subsequent gains.
All of which is to say investing isn’t easy. And, because humans tend to learn through personal experience rather than, say, reading stuff like this, we usually need to lose money to improve at it.
Are you the best person to manage your money?
That poses a conundrum for investors. If you’re not prepared to invest the time and exercise the discipline required to overcome the psychological biases from which we all suffer, and you aren’t prepared to lose some money along the way, are you the best person to be managing your money?
We can all be irrational. Making investment decisions on your own without rigorous peer review, nor many decades spent overcoming our inherent biases, is a sure way of achieving a poor result.
What’s the alternative? This is where managed funds and financial advisers come to the fore. When investors delegate their decisions to these professionals, they get a team of experts empowered to challenge each other to achieve superior performance.
Fund managers pool funds from like-minded investors to deliver a forecasted outcome that appears to make sense. By avoiding excessive risk through diversification, they can reduce many of the classic risks in decision making so clearly explained by behavioural economics.
By keeping a simple focus on the fund objectives, not promising excessive upside and explicitly managing for the downside, fund managers minimise the impact of the adverse human traits that undermine performance. Of course, fund managers charge for the privilege of managing your money. But if you’ve ever succumbed to herd instinct, overconfidence or emotionally-driven decision making, you’ll know the value of it.