Investors are their own worst enemy

Jason Zweig had a excellent article in the Wall Street Journal about how investors get worse returns by chasing hot performance right before it disappears.

Essentially, investors get much worse returns than the funds they invest in.  The reason: they sell what hasn’t been doing well and buy what has been doing well.  If they held the same fund over time, they’d get the same returns as the fund, but they buy and sell at the wrong time and get worse returns.

It’s not just individual investors who are prone to this–professionals investors do it, too.  The problem is that investors are paying professionals to do the same thing they would do, but then they end up even farther behind because they’ve also paid a professional fee.

Investing is simple, but not easy.  To get good returns, you need to choose the right principles, and then follow them through thick and thin.  That’s hard to do for most investors, especially because they pick professionals they like instead of the ones who are competent.

So was it ever.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Investors are their own worst enemy

Illusory Patterns

Some people’s investment results would improve from targeted brain damage.

This rather shocking statement is based on an article Jason Zweig wrote in the Wall Street Journal, “Why We’re Driven to Trade.” Neuroscience research has shown that specific parts of the brain contribute to certain decision making. More narrowly, researchers have found that one part of the brain, the frontopolar cortex, contributes to predicting rewards.

To better understand such decision making, researchers set up an experiment with three groups: two groups without brain damage and one group with damage to their frontopolar cortex. Then, they let the three groups play a series of games where the rewards varied unpredictably. 

What they found was that the two groups without brain damage tended to base their decisions on very recent data–their last two games played–whereas the group with brain damage tended to base their decisions on cumulative data of all the games they’d played. The more effective approach is to use cumulative instead of recent data.

Basically, the frontopolar cortex is a part of the brain that’s used to recognize patterns. It works great when there are useful patterns to be recognized, but when no patterns exist (as they don’t with random data) it goes right on recognizing illusory patterns that aren’t really there. 

The result is that when we run into rewards with unpredictable variability, our brains still tend to react as if it finding patterns (even though there are none). That’s why people with a damaged frontopolar cortex have an advantage in dealing with such circumstances: they don’t have a part of the brain that would recognize and act on illusory patterns.

This research holds lessons for investors, because investment returns–and you may have guessed this–vary unpredictably just like the game in the experiment. Like the two groups without brain damage, most people base their investing decisions on recent instead of cumulative results. This leads them to trade too frequently, selling something that has done poorly recently and buying something that has done well recently only to find what they bought does poorly and what they sold does well.

The good news is that you don’t need to damage your brain to invest better. Investors who base their decisions on long term, cumulative results instead of recent data can do just as well as those with a damaged frontopolar cortex. 

First, don’t buy just because a stock goes up or sell because a stock goes down. That’s basing your decision on recent data. Second, use long term, cumulative data to make decisions instead of short term, recent data. Third, make sure you have three reasons, outside of stock price movements, for deciding to buy or sell. And, last, keep track of your results so you can generate a cumulative record of what does and doesn’t work. This is best done by keeping track of what you sell as well as what you buy.

You don’t need brain damage to do better, you just need to create a deliberate decision making process that does an end-run around the part of your brain that sees illusory patterns. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Illusory Patterns

Don’t listen to a word I have to say

When you listen to a financial expert’s advice, your brain turns off.

This revelation came through Jason Zweig, who writes for the Wall Street Journal. In Zweig’s blog, he highlighted a recent study by Dr. Gregory Berns of Emory University.

In Dr. Berns study, he watched how people’s brain responded to inputs using a functional magnetic resonance imaging (fMRI) scanner. Specifically, he monitored blood flow to different parts of the brain of test subjects.

When subjects thought for themselves, two parts of their brain activated: one for determining the payoff of a sure win in the scenario presented, and one for calculating the possible gain from such a gamble.

Then, they did the same experiment, but with an “expert” with impressive sounding credentials. When that happened, the subject’s brain activity faded. In other words, once the expert started suggesting, the subject’s brain when into resting mode, “off-loading” the task of making the decision to the supposed “expert.”

It seems obvious to me that not everyone falls for this gag, but, it’s good to be aware of it.

I know I’ve paid for car maintenance I didn’t need because I tried to make a decision too quickly in the presence of an “expert,” so I feel keenly how easy it is to fall for such a trap.

How do you avoid “off-loading?”

Zweig suggests speaking to “experts” with a list of your concerns or the direction you’d like to go thought out and written down ahead of time. This will give you something to refer to when you’re talking to an “expert.”

Another thing he suggests is to make the decision later, after you’ve had a chance to think about it on your own. This lets you regain independence and get that blood flowing to the payout and gain portions of your brain.

There’s nothing wrong with listening to investing advice, but doing so without the right approach may lead you to do something you’ll regret.

So, listen to my advice, but turn it over in your mind on your own, think about what you thought beforehand, and give yourself some time before acting or deciding.

I always recommend this to my clients, too, because I’ve found I’d rather have happy clients for the long run than tricked clients that soon figure they aren’t happy with my approach. In the long run, the truth will out.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.