Step 2: A Guide To Successful Investing
Looking back over the last decade, if you had the ‘misfortune’ of investing in a fund that tracks the performance of global stock markets (MSCI All Country World Index) you would have experienced a temporary decline of -38% for the calendar year 2008. If you had the ability to remain invested, your money would have recovered, and your initial investment would have grown by 129%, as at the end of April 2019.
Step 2 – A Guide to Successful Investing
Keeping your Emotions in Check
Ben Graham, the legendary investor once said, “The investor’s chief problem, and even his worst enemy, is likely to be himself”. In theory, investing is relatively straight-forward, but it is not always easy, simply because money is emotional.
Psychologists have found that here are typically four conditions that can lead to poor decision-making:
- When there is incomplete information.
- When the problem is complex.
- When we interact with others.
- When we are involved in a stressful situation.
- The above conditions are all met when we invest. How can we help make better investment decisions?
Nobel Prize-winning psychologist Daniel Kahneman showed in his research that because of a bias called the affect heuristic, the human brain is very quick to make decisions based on intuitive feelings or hunches that require little thought. As we are continuously bombarded by information, this decision- making process, that Kahneman calls System 1, works wonderfully well for mundane everyday decisions. Unfortunately using System 1 type decision-making is never ideal when investing.
Kahneman also found that there was another part of the brain that is effective in using logic to make more reflective, clearer, and thoughtful decisions. He called this system 2, where people take the time to slow down and avoid making impulsive decisions. Slowing down and making long-term decisions is a start but it isn’t the only difficulty we face.
The hardest thing of all is to not get emotionally involved. We have a panic button which springs to life at perceived danger. When stock markets fall, or recessions are predicted we panic-sell. Interestingly, humans are fascinated in trying to seek patterns where none exist, a concept known as pareidolia. This is particularly acute when we try to look for and try to make sense of the movements in the stock market.
Learning to deal with your emotions is a crucial part of successful investing. Investing isn’t only about understanding what to invest in, it’s also about understanding how our own natural human inclinations and cognitive biases can wreak havoc on our decision-making process. You might be thinking to yourself that I’m a reasonably smart person. Surely, I’m smart enough to avoid these biases! Unfortunately, we are all prone (including financial planners & investment advisors!) to them.
Here’s what Henrik Cronqvist & Stephan Siegel had to say in their book, “Why Do Individuals Exhibit Investment Biases?”
“We find that a long list of investment biases for example, the reluctance to realize losses, performance chasing, and the home bias are human, in the sense that we are born with them. Genetic factors explain up to 45% of the variation in these biases across individuals. We cannot find any evidence that education is a significant moderator of genetic investment behavior.”
Emotional intelligence and an understanding of behavioural biases have a huge influence on us all. The simple message is that learning about biases will help you become a better investor.
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