Being a smart investor is not easy.
It requires discipline and rational thinking. Being focused on a long-term goal and being able to ignore the “noise” of the stock market, the media, politics and your neighbor’s free advice are all helpful.
Surprisingly, a good investor also must defy human nature. In today’s article we will review two facets of human nature that impact investors: The neuroscience involved in making a financial decision (in essence, the way our brains are “wired”) and the tendency to “follow the herd.”
Neuroscience
Two primary parts of our brain are involved in making financial decisions.
First, is the amygdala. It lies within the limbic system, and is often called the reflexive brain, the reptilian brain, or the lizard brain. It is located in the core of the brain, and it processes information rapidly and often subconsciously. The amygdala is where our intuition, emotions, perception of risk or reward, and first impressions originate. The amygdala causes us to seek rewards such as money, sex, alcohol and drugs. Impulsive behavior originates in the amygdala, along with anger, fear and greed.
The second component of the brain involved in financial decisions is the prefrontal cortex, which lies directly behind the forehead, and is often called the reflective brain. This is where analysis, weighing the pros and cons of an idea, and formulating a plan originate. The human brain has evolved with a larger prefrontal cortex than animals, which is what allows humans to think rationally.
Perhaps you find these two parts of the brain somewhat interesting, but you do not see how this relates to the financial decisions we make. They have a huge impact! The amygdala is what causes you to panic if the S&P 500 drops 30% tomorrow. If you are likely to be impulsive and fearful, you may sell your investments without thinking through the situation logically. This is a classic example of believing “the sky is falling,” and expecting the stock market to drop another 30% (or more) the next day. Wise investors do not make impulsive decisions based on fear and greed.
When the prefrontal cortex is activated after the S&P 500 falls 30%, logic prevails and the investor can think rationally. Once you become aware of how these two parts of the brain can conflict with each other, you can begin to understand how they can impact your decisions. When the stock market plummets, you may initially feel a tinge of fear, because you are fearful of the uncertainty of the stock market, and how a sharp downturn may impact your financial future. You can then deliberately turn off the fear, and look at the situation logically so you will not overreact.
For a more detailed explanation of the dynamic between different parts of the brain, see Daniel Kahneman’s book “Thinking, Fast and Slow.” Dr. Kahneman is a Nobel Laureate who spent much of his career showing that our decisions are not rational. His book is fascinating.
Following the herd
This dynamic has a major impact on financial decisions, and it has been labeled FOMO (fear of missing out). FOMO is what causes people to invest their money when the market is overpriced, and to sell after the market has plummeted.
In my opinion, much of the financial media encourages us to “follow the herd,” and deliberate action must be taken to not be sucked into the pressure.
Following the herd is encouraged by impulsivity and greed coming from the amygdala, and it can be avoided by using logical thinking from the prefrontal cortex. Warren Buffet advised against following the herd when he said “Be fearful when others are greedy, and greedy when others are fearful.”
In a recent example of irrational investing behavior, we saw GameStop stock skyrocket from $19.95 a share on Jan. 12 to $347 a share just 15 days later, when there was no fundamental reason for the increase. Amateur traders bet against hedge funds on Wall Street after the hedge funds “shorted” the shares of GameStop (they were betting that the share price would decline).
The amateurs saw this as a game, and their investments forced the share price to increase drastically. Many of the amateur traders trade on an app named Robinhood, which targets young investors and allows them to trade on “margin” (betting far more than their original investment), which can easily lead to huge losses.
Tragically, a 20-year-old man committed suicide in June of 2020 after believing he had a $730,000 negative cash balance in his Robinhood account. He was a college student, living with his parents in Illinois during the pandemic. His suicide note stated he had “no clue” what he was doing.
In my view, what I have seen happening on Robinhood and at certain other robo sites cannot end well. I consider investing to be a valuable skill. It should not include “winning big” or “losing big.” Investors should be educated to be logical and disciplined.
Recognizing that human nature (and the financial media) can encourage us to not be logical investors is a first step.
Be a smart investor
- Have a written long-term financial plan that includes specific goals and a net worth statement (updated annually).
Know your asset allocation target. What percentage do you want in the stock market vs. in fixed incom - Understand your loss tolerance. If it is low, keep your investments conservative.
- Educate yourself on investment fundamentals. Coursera and Khan Academy both offer free courses on many topics, including financial planning and investing. In addition, many financial firms offer educational material on their website. One to consider is https://investor.vanguard.com/investing/how-to-invest/.