Why are we so bad at investing?
For many years in TopFunds Guide we have highlighted humanity’s inherent inability at successful investment. We want to understand this in a bit more detail, as we believe it can transform the value of your investments over time.
With apologies to the psychiatrists and brain surgeons out there, think of the brain in 2 parts:
- the old brain
- the new, more recently developed, brain
Our old brain is extraordinary, a marvellous tool when we lived in caves, enabling us to make decisions rapidly whenever there might be a hint of a threat.
In contrast, the new brain (at least new in evolutionary terms) is more rational, thoughtful, but slower.
Our problem is that when we invest, the wrong part of the brain jumps into action. Consider this example.
Imagine you walked into a shoe shop, considering a purchase for a certain price, and then they announced you could have it half-price. How could you refuse! It wouldn’t take the rational front brain long to figure that out. Perhaps you would buy two pairs.
Now imagine you’re visiting your financial adviser, intending to invest. He enters the room, announces that share prices have halved. You run a mile!
And yet, bizarrely, if prices had recently doubled you would be more likely to buy. That’s not rational.
Uncertainty triggers “old brain”
That’s because your old brain is in play when you invest. There is so much uncertainty surrounding investments your old brain takes over, and makes the quick and dirty decision to flee – to avoid buying.
The old brain is very powerful, but it was developed for risks we encountered living in caves, when you could never be sure what lurked in the dense woodlands and undergrowth, when there was intense uncertainty. A split second of hesitation would threaten your survival.
Optimism is a default state
But when investing we also suffer from other psychological weaknesses.
For example, optimism (and the tendency to over-rate our abilities) appears to be a default state. Optimism is a great life strategy, but not an investment strategy. As a firm our greatest successes over the years have been derived from being cynical and knowing when to say “no”, such as not involving clients in the emotionally charged technology bubble.
Because investors herd, non-conformity, or going against the crowd, also hurts emotionally. So when the crowd is buying technology funds, an investor’s very strong instinct is to join them.
Last but not least, investors hate losses much more than they enjoy gains or success. So if one investment is losing money, and another is making money, we sell the winner! This is madness. But we convince ourselves (remember optimism and over confidence) that there isn’t really a loss unless we sell, and that the investment will work out eventually. This is one of the major reasons why so many private investors and fund managers perform poorly.
The world’s most successful investors are successful precisely because they sidestep these weaknesses.
For example, Warren Buffet identifies value in companies that others either can’t see or choose to ignore. He goes against the crowd, and is patient.
In contrast, George Soros will look out for an investment already going up, and he’ll jump on board, and stay on board for the ride - he goes with the crowd to an extent, and he won’t sell winners until very late in a trend.
It is important to try and take the emotion and uncertainty out of investing, as this can transform the success of your investments. We can help and will be coming back to this later in the year with detailed strategies which can be employed via our Wealth Management Platform.
In the meantime as the great investor Warren Buffett said:
“investing is simple but not easy”
(Taken from TopFunds Guide July 2011)