I recently read the book The Behavioural Investor by Daniel Crosby. Crosby is a psychologist who specialises in behavioural finance. Through his years of research, he found that humans tend to make bad investing decisions simply because of the way our brains are wired.
But it doesn’t have to be that way. We can learn to overcome some of our behavioural tendencies that cause poor investing decisions by learning and understanding the impact of human psychology.
Crosby explains:
“Understanding the impact of human physiology on investment decision-making is an underappreciated area of study that represents a unique source of advantage for the thoughtful investor.”
With that said, here are some things I learnt from his book.
Our brains were not designed for investing
It may seem strange, but our brains are not really designed to make investing decisions. Homo Sapiens have been around for close to 200,000 years and yet our brains have barely grown since then. A 154,000 year old homo sapien skull found in Ethiopia is believed to have held a brain similar to the size of the average person living today.
Essentially, that means our brains have remained relatively unchanged – although the world around us has changed dramatically. This resulted in emotional centres that helped guide primitive behaviour now being involved in processing complex financial decisions. This has, in turn, led to poor decision making.
Crosby explains:
“Rapid, decisive action may save a squirrel from an owl, but it certainly doesn’t help investors. In fact, a large body of research suggests that investors profit most when they do the least.”
“Behavioral economist Meir Statman cites research from Sweden showing that the heaviest traders lose 4% of their account value each year to trading costs and poor timing and that these results are consistent across the globe. Across 19 major stock exchanges, investors who made frequent changes trailed buy and hold investors by 1.5 percentage points per year.”
Our brains are hardwired to be impatient
Our brains are also hard-wired to seek out immediate rewards. This can lead to impulsive behaviour and poor investing decisions.
Crosby cited research from Ben McClure and colleagues who measure the brain activity of participants who made decisions based on immediate or delayed monetary rewards. According to the study, when the choices involved immediate rewards, the ventral stratum, medial orbitofrontal cortex, and medial prefrontal cortex were used. These are parts of the brain linked with impulsive behaviour.
On the other hand, the choices involving delayed rewards used the prefrontal and parietal cortex, parts of the brain that are associated with more careful consideration.
The experiment showed that our brains made more impulsive and greedy decisions when it comes to immediate reward.
Crosby explains:
“Your brain is primed for action, which is great news if you are in a war and awful news if you are an investor, fighting to save for your retirement.”
Our brain makes assumptions
Our brains have been hardwired to make quick decisions. This involves making assumptions, extrapolating patterns, and relying on cognitive shortcuts. As you can imagine, this can be a beautiful thing when it comes to saving energy for other functions of the body.
Unfortunately, making quick decisions based on cognitive shortcuts is by no means ideal when it comes to investing. These cognitive shortcuts can lead to poor decisions, cognitive biases and, ultimately poor returns.
A great example of cognitive shortcuts is the irrational primacy effect. This is the tendency to give greater weight to information that comes earlier in a list or a sentence.
The Good Investors’ Conclusion
The Behavioral Investor brings to light some of the more common human tendencies and why the human brain is not built to make sound investing decisions. But don’t let that deter you from investing.
We can overcome these behavioural tendencies simply through an awareness of what drives unhealthy behaviour and build processes to guard against poor investing decisions.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.