Over the past several months, our blog series on evidence-based investing has explored the ways we can use stock and bond market factors to help drive an effective investment strategy.
We turn now to what is arguably the most significant factor in evidence-based investing: 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 instincts and emotions that spur us to leap before looking.
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; 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. Often we don't recognize that we're making impulsive decisions. Our brain signals can trick us into believing that we're thinking rationally when, in fact, we're not thinking at all. This occurs when our deeply engrained instincts take over and highjack our brains with "survival of the fittest" reactions.
As neurologist and financial theorist William J. Bernstein put it: "Human nature turns out to be a virtual Petrie dish of financially pathologic behavior."
In short, our instinctive, impulsive reactions to market events can easily trump any other market challenges we face.
The field of behavioral finance studies the relationships between our heads and our financial health. What happens when we stir up that Petrie dish of financial pathogens? Wall Street Journal columnist Jason Zweig provides a guided tour of the findings in his book, "Your Money and Your Brain." In it, he describes both the counterproductive behaviors themselves and what is happening in our heads to generate them. A couple of examples:
- When markets tumble: Your brain's amygdala floods your bloodstream with corticosterone. Fear clutches at your stomach and every instinct screams "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!"
Along with such self-defeating market-timing instincts, your brain cooks up plenty of other insidious biases. There's confirmation, hindsight and recency bias, for example. Overconfidence is a common problem, as are loss aversion, sunken costs and herd mentality.
Managing the human factor in investing is another way an evidence-based financial advisor can add value. As Zweig observes, "Neuroeconomics shows that you will get the best results when you harness your emotions, not when you strangle them." By spotting when investors are falling prey to a behavioral bias, we can hold up an evidence-based mirror for them, so they can see it too. In next month's blog, we'll explore some of the more potent behavioral foibles investors face.