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Human brain (Photos.com)
Human brain (Photos.com)

Scott Barlow: Five ways human psychology can wreck your portfolio Add to ...

Scott Barlow is Globe Unlimited’s in-house market strategist and a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth. View more of his columns here that are available to subscribers only. For all investing content exclusive to subscribers, click here.

The emergence of homo sapiens as a species is estimated to have occurred more than 100,000 years ago in Africa. At the time, the human brain was nearly ideally suited to its main priorities which, in rough order, were: not being eaten by predators, finding food, social cohesion and procreation. Price-to-earnings ratios didn’t come up much.

Psychological adaptation continued from there as day-to-day life drastically changed (to say the least). Our mental responses to stimulus, however, are still are often dominated by subprograms such as “fight or flight” that were designed for the Serengeti Plain. Most of these processes make us terrible investors.

Here are my picks for the five ingrained psychological tendencies that investors must guard against to make investing more successful.

Loss aversion/anchoring

For investors, losses feel worse than gains feel good – losses have a larger psychological effect. This emotional emphasis on risk aversion made sense in an environment where not looking where you were going could result in being set upon by hyenas, but in investing it leads to “anchoring.”

Anchoring is what Tim Richards, author of Investing Psychology, calls “the mother of all behavioural biases.” It means that an investor who purchased a stock for say, $12, and saw it fall to $10, will not sell the stock even if they believe it was likely to fall to $5 or lower. The investor’s decision making is “anchored” to the $12 book value. Crystallizing the loss, $2 a share in this example, is so painful that they would rather convince themselves that the stock will recover rather than recognize the more likely event of steeper losses.

Herding

The need to be included with others is a usually laudable human tendency that can get an investing portfolio wrecked. The most dangerous application of the herding impulse for investors is the “I’m missing the rally” feeling. This most often results in buying rallies late, when they’re expensive and almost played out, and enduring the downside without enjoying the previous performance upside.

Choice supportive bias or confirmation bias

These are often listed separately but are at base the same thing – arranging (or ignoring) new information to confirm previous investment choices. Business Insider used the example of a dog owner to describe choice supportive bias as “Like you think your dog is awesome – even if it bites people sometimes.” Once people have made a choice, they are rooting for it, sometimes irrationally.

Most investors are familiar with confirmation bias. In most cases, this takes the form of reading only research or news reports that verify an existing investment opinion. The combination of choice supportive bias and confirmation bias means it takes considerable fortitude to read a negative research report on an existing investment. If anything, investors should have the reverse policy and constantly test their investment theses.

Recency bias

This is a big one in the current market environment. Recency bias describes the tendency to expect previous events to repeat themselves. Living in a jungle 20,000 years ago, it was entirely reasonable to expect that whatever happened last year would happen again this year. In a rapidly changing market environment, it can cause problems. This is particularly true only a few years removed from a once-in-a-generation financial crisis that scared almost every global investor half to death.

In the wake of the financial crisis, loss aversion makes recency bias worse. Recency bias makes investors feel like another great market calamity is right around the corner while loss aversion gives this emotion an outsized negative weight. Investors are likely more conservatively positioned than they would normally be as a result.

Outcome bias

This is the belief that a good investment outcome automatically means the process to select the investment is a good one. An “investor” throwing darts at the stock pages of the newspaper, buying the stocks where the dart hit, might consider this effective stock picking if the stocks outperform for the next 12 months.

The underlying problem in this case is that investment prices can only go in one of two directions: up or down. This doesn’t mean t the odds of investment profits are 50-50, but it does mean that many terrible reasons to buy a stock can result in positive returns, especially during a bull market. But only for a short while. Over the longer term, bad stock-picking will inevitably result in bad returns.

Princeton psychology professor Daniel Kahneman, Nobel Prize winner and author of Thinking, Fast and Slow, describes such psychological tendencies as those detailed above as “heuristics.” In other words, they are rules of thumb or shortcuts. Far from being wrong, Prof. Kahneman details why heuristics are actually extremely effective and efficient in day-to-day life.

According to Prof. Kahneman, in activities such as investing or physics research where success is often the result of objective counterintuitive thinking, however, the human brain must throw the heuristics aside and “think slow.” For investors, it is important to question our thinking – knowing when our brains are on autopilot with modes of thinking better suited to survival thousands of years ago, and when we’re making rational, objective decisions in our portfolios.

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Follow on Twitter: @SBarlow_ROB

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