Key Investment Insights: The Human Factor in Evidence-Based Investing

October 9, 2014
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Welcome to the next installment in our series of Key Investment Insights.

In our last piece, “What Has Evidence-Based Investing Done for Me Lately?” we wrapped up our conversation about ways to employ stock and bond market factors within a disciplined investment strategy.  Our goal was to find new evidence-based insights from more recent research.

We turn now to the final and, arguably, most significant factor in your evidence-based investment strategy: the human factor.  In short, your own often impulsive reactions to market-changing events can easily trump any other market challenges you might face.

Exploring the Human Factor

We may know everything there is to know about capital markets, and we may be cognizant of all the solid evidence available to guide our rational decisions, but the fact is, in spite of all that, we’re still human. You see in the previous sentence that word “rational;” well, the truth is sometimes we’re just not.  We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions.  Rather, what we’ve got churning and brewing are chemically generated instincts and emotions that could spur us to leap long before we have time to look.

Physiologically, rapid reflexes often serve us well.  Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running without pause to think, while his or her laughter elicits an instant outpouring of love.

But in finance, where it is said only the coolest heads prevail, many of our baser instincts can cause more harm than good. If you don’t know that they’re happening or don’t manage them when they do, your brain signals can trick you into believing you’re making an entirely rational decision when, in fact, you’re being overpowered by an ill-placed and ill-timed “survival of the fittest” reaction.

Put another way, neurologist and financial theorist William J. Bernstein, M.D., Ph.D. says, “Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.”

Behavioral Finance, Human Finance

To study the relationships between our head and our financial health, there is another field of evidence-based inquiry known as behavioral finance. What happens when we stir up that Petrie dish of financial pathogens?

Wall Street Journal columnist Jason Zweig’s “Your Money and Your Brain” provides a good guided tour of the findings, describing both the behaviors and the goings on inside your head which can generate those behaviors; for example:

  • When markets tumble – Your brain’s amygdala floods your bloodstream with corticosterone. Fear clutches at your stomach and every instinct points the needle to “Sell!”
  • When markets unexpectedly soar – Your brain’s reflexive nucleus fires up within the nether regions of your frontal lobe. Greed grabs you by the collar, convincing you that you had best act soon if you want to carpe diem and “Buy!”

An Advisor’s Greatest Role: Managing the Human Factor

Beyond such market-timing instincts that can lead you astray, your brain cooks up plenty of other insidious biases to influence your investment activities. To name but a few, there’s also confirmation bias, hindsight bias, recency bias, overconfidence, loss aversion, sunken costs and herd mentality.  Given the myriad of instinctual responses that can lead you astray, it’s not easy to remain calm and “stay the course.”  The soundest decision is to have an impartial and unbiased investment advisor help you remain on the path you have carefully chosen.

DFA Investment Principles Slide 25

 

 

 

 

 

 

 

You can click on the graph for a better view.  Then click back to continue reading.

Your Takeaway

Managing the human factor in investing is another way an evidence-based financial practitioner can add value.  Zweig observes, “Neuroeconomics shows that you will get the best results when you harness your emotions, not when you strangle them.”  By spotting when investors are falling prey to a behavioral bias, we can hold up an evidence-based mirror for them, so they can see it too.  In our next piece, we’ll explore some of the more potent behavioral foibles investors face.

Comments

One Response to “Key Investment Insights: The Human Factor in Evidence-Based Investing”

  1. Arnold Waldman on October 10th, 2014 8:40 am

    Well-written! We humans are programmed to follow mob behavior, which means buying when the market is going up and everybody is talking about the money they are making in the market; and selling when the market is going down and everybody is depressed about it. This mob instinct guarantees that we will buy high and sell low. Acting rationally according to a long-term plan is a challenge for the best of us!