Let me first say that, if any neuroscientist reads this, I’m not one. This is a very basic account of the brain and how it can affect investment behaviors.
This post was originally published in September 2017. It has not been updated.
According to an annual study conducted by a company called Dalbar, in the 20 years from 1997 to 2016, the average investor gained a tiny average of 2.3% per year, whereas the average annual return of the S&P 500 (US stock market index) was 7.7%.[i] During that time there was the East Asian Financial Crisis, the tech bubble, 9/11, the Global Financial Crisis of 2008, a Japanese Tsunami, multiple wars, the European sovereign debt crisis, a US credit rating downgrade, and a handful of other negative events. If the stock market returned an average of 7.7% annually and so many people like investing in index funds, why did the average investor only experience a 2.3% average annual return? It’s because people have a tendency to invest using only their “animal brains” and don’t understand how to switch on their “human brains” to make better investing choices. Our animal brain causes us to seek fast rewards at great costs. It drives addiction and addiction behaviors. It also drives terrible investment choices. We shouldn’t make investment decisions like animals or cavemen. Let me start with a story about a client who has since reformed the way he treats investing. In order to protect his privacy, I have changed a few details of the story such as his name and his total account value. Then we’ll move on to how some of these behaviors have been seen in lab rats.
In 2011, I was fired by a client. It’s not often you’ll hear an advisor admit to being fired by a client, but it happens to us all the time for a variety of reasons. This particular client was a chemical engineer in his mid-40s. He felt that he could do better managing his own investments and do it at a lower cost. It’s very reasonable for someone with his education to believe he’s capable of analyzing and choosing investments on his own. We’ll call this man Dave.
At the end of 2012, Dave and his wife returned to my office. It turns out the wife had encouraged the return and Dave had a big admission to make. During that year, when a low-cost index fund would have given him a 16% return, he’d lost 40% of his account value investing on his own. To put that into perspective $100,000 would now be $60,000. But, Dave had been investing a lot more than $100,000. Let’s just use $100,000 going forward for the example. In the meeting Dave said he’d like to open accounts and transfer in what was left. He wanted me to “make it all back” for him . . . in a year.
The big misconception about financial advisors or investment advisors is that we have access to some magical crystal ball that allows us to see the future and buy just the right investments to meet any goal the client might bring to the table. In reality, we (should, though some advisors don’t) address client goals and try to set realistic expectations around meeting those goals on specific time lines. What Dave was asking me to do was grow his theoretical $60,000 to $100,000. He lost 40%, but to make $40,000 back on $60,000 would require a 66.67% return in one year. Unfortunately for Dave, this was not a realistic expectation, and I had to explain that to him. I wish I had that crystal ball that’s expected by people like Dave. If I did, I wouldn’t tell anyone else, and I’d have weathered Hurricane Irma in the wine cellar of my home on my private island like Richard Branson did this past week.
Dave and his wife (I think she was the brains behind this one) took my advice and my honesty and became clients again. Before I started investing Dave’s money for the second time, I wanted to understand what had happened in the 14 months since he’d moved his account. It appeared Dave had held what we call “heavily concentrated stock positions,” that is, just a few stocks, not well diversified. I asked him how he’d selected them and he’d found them via a few sources. One source was one of his managers, another engineer, who’d told Dave about some purchases he’d made that he just knew were going to have astronomical returns based on some new medical device patent, or some invention of the next big tech gadget. He’d also picked up a few based on an email subscription newsletter. The first failing was that Dave hadn’t done any actual analysis of his purchases. Second, he was buying based on speculation, gambling in hopes of a big return. Third, he wasn’t diversified. And, the fourth mistake he made was possibly the biggest.
Dave sold on emotion. As many advisors will tell you, investing is a marathon and not a sprint. Investing long term isn’t sexy, but it’s prudent. Every time one of Dave’s speculative holdings would take a dive, losing value, Dave would sell out of it and write it off as not being the big investment that was going to make him money. Let’s take a look at an illustration of what happens when people do this:
I like to use fake company Imaginary PTC, Inc. for my examples. Let’s say Imaginary was recommended to Dave at a backyard party over a bowl of guacamole. Bob made the recommendation and said “oh yes, Imaginary has found a cure for cancer and patented it. I read it last week. I’m going to invest and you should too. This thing is going to blow up and we need to get in now.” So, after the party, Dave logged into his discount brokerage self-directed trading account and invested about 1/5 of all his assets into Imaginary PTC, Inc. at a price of $10 per share. That’s $20,000. So, he then held 2,000 shares of that company. Let’s assume Dave allocated the rest of his $100,000 based on similar information into four other companies. Now his $100,000 was invested in the stocks of only five companies based on purely speculative hearsay. He was salivating over the prospect of making big bucks and getting to retire early, effectively hitting the lottery or jackpot of the stock market. The way he described his purchases, I could imagine he felt wild with anticipation at this prospect when he made the purchases.
Here’s how the average person experiences emotions in market ups and downs:
Our friend Dave was selling his investments when he felt anxiety or panic. Most advisors will explain that when we determine we’re going to buy something, the point on a chart where we know we have the most potential for return is to buy at the bottom, where the word “panic” is located. The caveat to this is that you have to know that’s the bottom (where’s my crystal ball?) and the investment has to be worth actually buying. There are lots of crap investments that aren’t worth buying, and instead of this curve heading back toward optimism, it continues down beyond panic and into the toilet. But, let’s assume Dave’s investments were worth buying, he just couldn’t hold out for the marathon. He was selling at “panic,” at the bottom. We should ideally sell high, but if the investment is bad, you have to let it loose. Dave wasn’t analyzing whether or not his investments were bad. He was just selling because he’d sustained losses that made him feel emotionally negative, not just financially negative. What does that do to a person’s account value?
Step into Dave’s shoes. If you start with $100,000 and sell your investments because your account value is now $86,000 then you’ve locked in your losses, or “realized” them. Then, you move onto other investments discussed over guacamole and just know these are going to be the ones to make up those losses and then some. You’ll hit the investment lottery or jackpot this time for sure. But, after climbing to $94,000, the market takes a dive and you ride the downturn, selling when you panic again at $78,000. The next time, you think better of learning about investments over guacamole. So, you subscribe to a newsletter you learned about from a colleague while standing at the copy machine at work. You buy a few things from the newsletter, but only have $78,000 to start. Those investments lose money and you’re down to $70,000 so you sell. And repeat. And repeat. And repeat. You have a shrinking account value, and that is not investing.
There are lots of other ways this can happen to an investor besides guacamole and copy machines. I’ve seen some extreme cases worse than Dave’s. A friend of mine recently told me that he’s really into trading options. Options are contracts agreeing to buy or sell stocks at a given price to another investor. These contracts can be bought and sold. When used correctly they can hedge against losses, or be used to take advantage of upside of a stock. But, the crazy thing about options is that, if you sell a contract to another investor, agreeing to sell that investor your shares at a given price in the future, and the stock reaches that price, you actually have to sell your stock. That means your stock probably reached a lower price. That means you’re selling low. That means you were BETTING, gambling on the price of a stock. It’s a good way to lose your ass if you don’t know what you’re doing. The crazier thing about options, is that you can trade these contracts even if you don’t own the stocks. You can offer contracts to sell stocks that you don’t own. Yes, that’s what I’m saying. This friend will probably read this and smile because I lecture him about the dangers of gambling with investments. But, he’s not the only person I’ve seen do this. I know a lot of people who’ve done this and in fact there are blogs and sub-Reddits dedicated to discussions on trading options. Here’s the thing: People do this because they can make quite a bit of money in a very short amount of time if they buy or sell the right contracts, and they’ll happily tell you about how much money they made on a trade unless they lost thousands of dollars. Losing is much more common in the options trading game, but no one is going to tell you how much they lost.
Do you know a gambler who goes to casinos all the time? That person will happily tell you how much they won, but they’ll never disclose what they lost on a bad bet. Casinos are in business because the house wins most of the time. Yet, gambling addicts continue to gamble because they love the rush of winning. They get a high anticipating the emotional roller coaster. They must experience the downs to get a rush on the ups. Someone with a gambling-addict mentality will tell you only about the successful investments he or she has made and never tell you about the bad ones.
This all comes down to our biology and can be explained through neuroscience—brain science. I’m not a neuroscientist, but there are lots of studies that can be referenced to explain why people treat investing like gambling. The first step someone must take to stop treating investing like gambling is to recognize the behavior. The second step is to use a different part of the brain.
There are many parts to our brains and we’ll discuss them in very basic terms starting with the “brain reward system.” This is part of a larger part of our brain that is the same in animals. There are parts of the human brain that are similar to the brains of reptiles. Layered on that are parts of the brain that are similar to the brains of other mammals. Then there’s the prefrontal cortex which gives us control over our animal instincts and allows us to be rational. Additionally, humans have a large number of a specific kind of neuron that are shared with very few other species, such as elephants, that allow us to feel other more complex emotions such as empathy.
The “brain reward system” is part of the limbic system which controls emotions and desire. It’s our motivator. It’s a specific part of the limbic system that tells us “if I do this it will feel good.” Historically, this has served us well. It drives us to seek pleasure or feelings of reward. Those feelings can come from an adrenaline rush, anticipation of eating or the kill in hunting (think prehistoric hunter gatherer types needing a reward function to motivate them to hunt for food for survival), sex (for procreation), and so on. This animalistic reward system has a lot to do with survival. However, we can go to the grocery store, and that’s not exactly fun. Most of us in America live in adequate shelters and have very little in common with cave men in terms of stressors in our day to day lives. So, this reward system drives us in different ways. Some of those ways are positive, and many can be negative. This system has a lot to do with addiction. In fact, it was when someone near and dear to me battled with addiction that I started doing some research to learn about the brain and found that, in addition to having a lot to do with addiction, it also has a lot to do with the way people make investment decisions.
In the absence of certain stressors in our surroundings, such as sabretooth tigers, we’ve developed other stressors such as traffic jams on long commutes. When humans need to feel good, instead of the excitement of the hunt, some people put on their game day faces and jerseys and get fired up watching their favorite football team. When we vacation, we go to places that are visually stimulating offering a sensory reward. Or, we may go hit the ski slopes or engage in another activity that fuels our adrenaline. After work we may unwind with an alcoholic beverage. These activities create hormone responses, which in turn create dopamine via a part of the brain reward system called the ventral tegmental area (VTA), which is then sent to the nucleus accumbens causing a person to feel pleasure. Thus, the reward is received. The limbic system is the part of the brain that drives pleasure, fight or flight responses to dangers, and addiction. As an aside, I sat in on a presentation in July discussing the fact that these same systems in the brain are the reason mothers wake up to their babies’ cries at night but fathers sleep through them. I had to apologize to my husband after finding out that he wasn’t actually ignoring the baby and intentionally contributing to my sleep loss nine years ago.
When humans give into the limbic system and the prehistoric reward system in modern day, we experience substance abuse, alcohol addiction, sex addiction, adrenaline addiction, shopping addiction and a whole host of other behaviors. The two prehistoric behaviors that impact the way we invest the most are the flight response and the reward system. An article from Harvard Business Review[ii] discusses the brain and the way these processes impact our relationship with money. The article mentions a study in which rats had electrodes implanted near the nucleus accumbens. The rats learned that they could press a button which would stimulate the area creating a feeling of pleasure and they began pressing the button “to stimulate the area until they [dropped] from exhaustion.” The context of the rat discussion in the article references another study conducted at Stanford University in which human participants were told they were going to receive money, and their brains’ responses were measured. The study ended up showing that it was not the receipt of money which cause a significant response, but that it was the anticipation of receiving the money. So, if we imagine for a second someone with a gambling addiction or someone who treats investing like gambling, that person would become very aroused at the possibility of winning, and the brain’s reward system would crave that feeling that the person has when he or she is anticipating receiving money. In a caveman, this feeling would have fueled the hunt for food to survive. But, instead, it turns people into the rat with the arousal button, pressing it again and again and again.
Discussing the flight response, we’ll think about bugs for a moment. Even if any bug makes you squeamish, most everyone can agree that there are bugs that are beneficial, bugs that are vulnerable to being squished, bugs that you avoid, and bugs that make you take flight to get away from them. Let me peddle backwards for a moment. People generally learn when a fight or flight response is appropriate through processing an experience or information. So, if you see a furry caterpillar that looks cute and you choose to pick it up and it stings you because it was an asp, you are not going to pick up that type of caterpillar again, and you might be reluctant to pick up any cute and furry caterpillar ever again. You might also learn to avoid that asp if you see another person get stung, or if someone shows you a photo of one and says “Don’t touch this. It will sting you and it hurts like hell.” When my son was little and we were working on developing his responses, an acquaintance told me about the “freak out game.” The way she explained it was that if her daughter started freaking out about something stupid, like her meats and vegetables touching on her dinner plate, she and her husband would start talking asking questions like “Is this really something we freak out about? Would we freak out if a bird got in the house and started flying around and knocking things over?” Her examples for her daughter would grow and grow. Eventually they would get really big, like “If a lion escapes from the zoo and is in the front yard do we freak out?” You can see how this fun game would give kids some perspective. Perspective is something we all must have to get our fight or flight response down pat and conserve energy for more worthwhile things in life. So back to the bugs. We addressed that the asp could be avoided. In Texas, if I get stung by a fire ant you can bet I’m going to crush it because those aren’t always avoidable and I hate them. If I accidentally disturb a hornets’ nest I’m going to take flight and run for cover. And, if I see a butterfly pollinating my vegetable garden I’m not going to bother it. Now imagine that you are a person who’s never seen any of those bugs, and all the information you’ve ever received has been from people who’ve been stung by bugs. You are either going to want to avoid all bugs, squish all bugs, or run away screaming every time you see a bug.
Stocks move up and down in response to a lot of different factors and it’s common for the stock market to lose 5% from its most recent high at least a couple times in a year. Event 10% downturns are very normal. In the portfolio primer webinars that are scheduled for next week I will discuss some of the factors that contribute to these changes in the prices of stocks. But, for now, I’m just going to say that sometimes the stock market drops a lot. For inexperienced investors, this creates the feeling of panic shown in the investor emotion chart. For experienced investors, it’s an opportunity to pick up high quality investments when they’re on sale. The average investor feels the desire to sell when he or she logs in online and sees a major drop in account value, or to change investments, or to fire the advisor. This is fight or flight. But, selling or switching investments isn’t always the best idea and sometimes it results in locking in losses, like what happened to Dave. Instead, investors need to carefully analyze their investments and make sure they are buying butterflies but not asps or fire ants, and then to try to pick up those investments when they’re selling at the right price. Not all stocks should be feared. A good advisor will explain what you own and help you manage that fight or flight response you might have to normal market movement.
It’s also important, as mentioned earlier, to avoid gambling with investments. Gambling and investing are not the same thing, and if that’s what you’re doing then you’ll find it very difficult to come out on top. You must recognize that your behavior may be motivated by the more animalistic parts of your brain. To recognize brain reward behaviors or irrational fight, flight or avoidance, you have to activate the human part of your brain.
An article published in the journal Biological Psychiatry called “Prefrontal Cortex and Impulsive Decision Making” examines the relationship between the prefrontal cortex, which makes us human, and impulse control.[iii] The prefrontal cortex gives us “common sense.” It allows us to use rational thinking and analyze our own behaviors. This portion of the brain is said to not be fully developed until the age of 25. Experiences and environmental factors can affect the way the prefrontal cortex develops, the way neurons make connections, and the impulses that we learn to control. Remember the freak out game? The freak out game is just one way that those neurons make connections. Exploring, experimenting, making mistakes, and learning all contribute to the amount of control a person has over impulses. Societal norms, religious beliefs, laws, and an understanding of right and wrong can contribute.
The prefrontal cortex is the thing that people refer to as a conscience. You might think of the impulses coming from the animal brain as the devil on one shoulder and the human corrections coming from your prefrontal cortex as the angel on the other shoulder. The prefrontal cortex doesn’t just prevent us from doing things that are wrong. It also helps us to keep irrational behaviors in check. By learning the differences between bugs or investments, humans can learn how to shut down the wrong responses. You wouldn’t crush a butterfly and you wouldn’t sell a perfectly good investment just because the price is lower than when you purchased it. That’s the prefrontal cortex in action. For addicts, sometimes the prefrontal cortex simply can’t overcome the impulses coming from the brain’s reward system—the thing that makes us like the rats that push the reward button until they fall over.
The prefrontal cortex can function to curb gambling type behaviors if the person suffering from the addiction or condition can first acknowledge that it’s a problem. Once the problem is acknowledged some people are capable of curbing it themselves through simple awareness, but true addicts may require treatment and therapy for a long enough time period to allow for the prefrontal cortex to make new connections with other parts of the brain. The scholarly article mentioned above says this about impulses:
Impulsive inter-temporal choice refers to the tendency to forego a large but delayed reward and to seek an inferior but more immediate reward, whereas impulsive motor responses also result when the subjects fail to suppress inappropriate automatic behaviors. In addition, impulsive actions can be produced when too much emphasis is placed on speed rather than accuracy in a wide range of behaviors, including perceptual decision making.
Does “the tendency to forego a large but delayed reward and to seek an inferior but more immediate reward” sound familiar? Remember investing is a marathon and not a sprint? Decision making occurs when we use our prefrontal cortex to evaluate both short-term and long-term rewards and make a choice that is wiser, even without near term gratification. Decision making also encourages us to incorporate higher quality information—the information that allows us to evaluate bugs or investments.
In Dave’s case, he had two things working against him. It turned out that Dave had some addictions aside from investing and an addiction to gambling was manifesting itself in his investment decisions. Through consistent contact and discussions around decisions, Dave has learned not to let the desire for short term reward become stronger than the rational decision to wait for a better but longer-term reward. He also has recovered from some of his other addictions thanks to some therapy and the support of his wife. The second thing Dave had working against him was an irrational fear of market turbulence even when he was holding quality investments. Dave has also curbed his responses to those. I enjoy seeing his ability to become quickly introspective and recognize when his initial reactions are the wrong reactions. I know I recognized the difference in the way he processed information. But, until July of this year, when I started doing the research, I wasn’t able to connect the dots and fully understand the relationship between our biology and our behaviors, and the way that makes us think about investments.
The first step in correcting behavior is to recognize the behavior. Are you guilty of bad investment or financial behaviors? If you said yes, then you’re capable of recognizing them. Now, can you evaluate your alternatives in the decision-making process?
[i] Source: Dalbar, Inc.
[ii] Source: Morse, Gardiner. “Decisions and Desire.” Harvard Business Review. January 2006. Accessed September 11, 2017. https://hbr.org/2006/01/decisions-and-desire
[iii] Source: Kim, Soyoun and Lee, Daeyeol. “Prefrontal Cortex and Impulsive Decision Making.” Biological Psychiatry. August 2010. Accessed September 11, 2017. https://www.ncbi.nlm.nih.gov/pmc/articles/PMC2991430/
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