My first post on the topic of behavioural finance introduced the idea that investors, rather than listening to logic that tells them to buy low and sell high, do just the opposite and let their emotions drive investment decisions – buying high and selling low.
Before jumping into some of the biases we experience when emotions affect the investment decision-making process, I thought it would be helpful to explain why many still find themselves making irrational investment decisions. What must first be understood is that we are not in fact letting our emotions take over, but rather experiencing a natural tendency that we must fight in order to invest rationally.
Our story begins in the African Savannah, at the dawn of the human brain. The brain contained then, as it does now, three basic parts:
- The “reptilian” brain, which we share with reptiles. It is the most primitive section of the brain and controls our basic body functions, like our breathing or heartbeat.
- The “limbic” brain, which we share with mammals. This is where most of our emotions reside. This is also the location of the amygdala, which plays a primary role in the formation and storage of memories associated with emotional events.
- The “neocortex,” which only humans possess. It is responsible for high-level reasoning and judgment.
The brain was built to prioritize first and foremost our survival. Survival on the Savannah meant the ability to make snap decisions to flee, for example, when a saber tooth tiger crossed our path. When stressed, the primitive brain took control, releasing adrenaline and cortisol into the brain that triggered a flight response – “RUN!”
Now contrast this with our current lifestyle. Society has evolved at an exponential pace and the brain, still built more or less for Savannah survival, has been left behind in the dust. There is much to fear in an investment world that is quick-paced and overloaded with information. With little change to the brain since the time of saber tooth tigers, we have the same flee response (albeit on a smaller scale) when we experience a loss in the market – “SELL!” And to make matters worse, the cortisol that is released by our brains fuses that flee experience into our memories, impacting our buy/sell decisions going forward (the birth of biases that are detrimental to decision-making – more on this in future posts).
We face another tendency when markets rise. Similar to drug addicts, who receive a surge of the brain chemical dopamine when expecting their next dose, investors experience a surge of dopamine just from the thought of making money in the market. The dopamine surge can affect rational thought and increase our willingness to take on greater market risk – “BUY!” This tendency can have a detrimental effect on our long-term investment goals, as emotion supplants reason – and provides a window into the irrationality that leads to market bubbles.
As I mentioned, these are natural reactions. Everyone experiences them, no matter their level of investment knowledge. So, the goal is not to eliminate these tendencies, but rather to recognize and control them. Bob Hager, co-founder of Philips, Hager & North, was once quoted saying, “My best trades turned out to be the ones when my hand was shaking as I gave [the equity trader] the blue ticket.” Even though his flee response kicked in when he was buying a stock that was out of favour in the market, he was able to control the tendency, rather than allow it to get the best of him, and follow through with his trade. Similarly, Burgundy’s Portfolio Managers have gained the necessary experience to recognize those primitive tendencies – the hand-shaking attributable to a down market or the excitable jitters of an up market – and move past them in order to buy low or sell high.
The takeaway here is that human fear/greed responses are counterproductive to our long-term investment goals. Though they may be natural tendencies, we must learn the discipline to brush them aside in order to achieve investment success. The primitive reaction has no place in our contemporary investment worlds. The more we give it free reign, the more it will affect us. And the more discipline we learn, the more rational our investment decisions will be – increasing the chances of achieving our long-term investment goals.