Psychology, neurology and investment

How do you make investment decisions? Are they rational, repeatable and free from bias? Are they optimal? Michael Falk, a partner at Focus Consulting argues that unless you invest using defined processes to govern every single buy and sell decision you make – your decisions will not always be optimal.

That is because human decision-making is strongly influenced by unconscious processes within the brain, by external stimuli and by hormones. “Your body makes a large, if not greater part of your decisions,” Falk says.

Falk was talking to investment professionals at the recent Morningstar Investment Conference in Cape Town.

One of the best-known pieces of academic research on the subject of behavioral bias, suggests that investors tend to feel more optimistic on sunny days. This leads them to take more risks, open more positions and take on more exposure in the markets. What is notable about the research, says Falk, is that it has never been challenged. “So the next time you want to bet on that ‘sure thing’ look out the window and see if the sun is shining.”

Over a 40-year period, share prices tended to rise when it was sunny in New York City and fall when the clouds reappeared to cast a shadow on investors’ mood. This effect is enhanced when markets are unstable, he says. Between 2000 – 2008 this effect was quite negligible, but became more pronounced after 2008, when the global financial crisis hit.

The weather is not the only thing that influences sell and buy decisions.

Nobel laureate and academic, Herbert Simon coined the terms bounded rationality and satisficing, which is an amalgam of satisfies and suffices. “Simon suggests that we don’t maximise or optimise our decision making, we satisfice – we do just what is good enough – based on the available information and limited time and ability to process that information,” Falk says.

Moving from psychology to neurology he asks: “What is the two and 20 principle?” It’s the brain’s weight to energy ratio. “The human brain accounts for 2% of a body’s total mass but it consumes 20% of a body’s energy consumption. It’s an energy hog,” Falk says.

This influences how we process information. The brain is driven to economise a body’s scarce metabolic resources, according to Paul Zac, a neural scientist whose research came to the fore in the early 2000s. “When the brain is working it takes up a lot of energy. Its goal is to economise. As a result, ‘good enough’ prevails,” says Falk.

The thinking of the two academics, separated by almost thirty years, supports the idea that the brain creates biases and heuristics to solve problems quickly and save energy. Heuristics are decision-making short-cuts which don’t require a lot of effort. They rely upon the power of stereotypes, past experiences or easy ways of calculating numbers to provide an approximate answer.

These can be very effective when they are well-matched to the decision at hand - such as following a crowd to find your way to a sporting event, but badly in others, like investing.

“Investing is all about decisions. But the decisions we make are based on emotions and information – which isn’t always new,” says Falk. “Information is based on our experience and knowledge and what we have learned. We compare and contrast what we are learning with what we already know and try to fit it together. It’s easier. It’s faster. It’s more economical.”

Environmental stimuli shape our decisions. In a study to show the effect of sound on decision-making, a liquor store played German music on one day and French on another. “Wine sales were biased by a statistically significant amount towards the country whose music was playing on the day, suggesting that auditory stimuli can affect purchase behavior,” says Falk.

So before making important (investment) decisions, consider what is driving those decisions. What is your present state? Your unconscious may have already decided for you.

Falk has some suggestions to counter the impact of biases in investment decision-making:

  • Respect your environment. What happened this morning? Are you in a good mind space to trade? If not – don’t!
  • Use a checklist prior to any trading.
  • Have a decision process for both buys and sells. “Most investors don’t have a process for sells. You should have a sell discipline. That is where additional alpha is made.”
  • Make fewer decisions, slower. “There is nothing wrong with emotion, it helps you make decisions, but manage emotions in order to make better decisions.”
  • Wait for the fat pitches: don’t feel under pressure to trade. You can raise your investment batting average by waiting for the pitcher - Mr Market - to throw you a nice fat pitch right down the middle of the strike zone.
  • Pre commit – if you are waiting for a stock to drop in price – put an option on it. It is statistically proven that very few of you will buy it when it drops.
  • Keep a journal

“Monitor your trades and investment ideas and how you felt at the time. It’s hard work, but you might learn something about yourself. This avoids ‘hindsight bias’ where you look back on former decisions and rejudge them as appropriate.”

*Did your activity add value?

*How did your ‘watch list’ perform? Do you ever do due diligence on this? If it performs perhaps you are not taking enough risk

*How do your stocks perform once you have sold them?

*How did your most vs least confident trades perform?

Over time, he says, investors will learn when to make decisions and what decisions they are good at. “I learned I was crap at picking tech stocks. So I farmed it out. Play to your strengths.”

“Behavioural biases are a fact of life, and they are not all bad” Falk adds.

Just don’t leave it up to instinct.

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