Between 1980 and 1992, the most successful fund in the United States compounded annually at more than 25%; however, most investors lost money. How is that possible? Well, the average investor held the fund for seven months. Many investors then, and many investors now, forget that building wealth takes time and patience.
We live in an era where everything is driven by technology, and we have constant access to information via an array of electronic devices, starting with smartphones. We are able to evaluate our investments weekly, daily, and even, if we so choose, we can evaluate them every fifteen minutes. Can you imagine if you were able to do this with the value of your home? Would you check the fluctuation of its value this frequently? I believe most would say no, because after all, a home is typically a long-term purchase. However, many investors who are investing for the long term are watching their investments daily, and are tempted to pull out if they see fluctuations.
James O’Shaughnessy, in a book called “What Works on Wall Street”, referred to a study by Baba Shiv of Stanford University, which showed that people who had suffered brain damage, specifically damage to the amygdala or the insula regions of the brain, tend to make better investment decisions and get better rate of returns than healthy individuals. The amygdala and insula are the parts of the brain that deal with risks, and unlike the healthy test subjects, who had become averse in reaction to previous losses, the test subjects who had brain damage were able to approach each investment anew, without allowing their emotions to get the better of them. Our brains, which have been wired to protect us from risk, have served us well throughout the centuries; but they are not particularly well adjusted to today’s way of life, and may create havoc when the market takes a bit of a dip.
The brain is responsible for decision-making. In particular, the two parts responsible for this crucial function are the Central Limbic System and the Prefrontal Cortex, called System 1 and System 2 respectively by Psychologist Keith Stanovich and Richard West. In “Thinking Fast and Slow”, Daniel Kahneman showed how System 1 was used to make emotional decisions, and System 2 to make rational decisions. Specifically, System 1 determines whether there is a threat and whether you should stay the course or escape, usually with an emphasis on a fear of loss. For situations you are not familiar with, System 1 relies on information, ideas, or events from your memory, and a solid dose of mental shortcuts, to make rapid decisions. Say, you are confronted with a bear in the woods: there is a solid chance that System 1 will tell you to flee. Now as you can imagine, if there is a market correction and this is your first time dealing with this type of loss, System 1 may treat it as it did the bear encounter. This may lead to a “flight situation” (and a mass liquidation of your investments), because your brain has determined that it is the best decision in order to avoid any additional fear. All of this may happen before System 2, the more logical part of the brain, gets engaged. Of course, selling means you will miss out on the returns when the market rallies. Investors who have done well in the market will agree that as humans, our erratic emotions and actions are rooted in psychological forces that drive most of the poor results that investors experience in the market. Warren Buffet, who many have considered to be one of the savviest investors of all times, once said: “[T]o invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight or inside information. What is needed is a sound intellectual framework for decisions and the ability to keep emotions from corroding the framework.” History has shown that Warren Buffet is correct.
Nonetheless, in a time where you have millions of opinions at our fingertips via a smartphone, you may now be bombarded with information leading to erratic and irrational decisions. In a world of instant gratification, many are looking for returns without risk or time. Some want consistency without any type of volatility. A better approach with regard to return would be to consider what are your five or ten goals, and what rate of return is required to achieve them before reading your statements, watching the financial news, or deciding to pull your money from the market. Also, consider that if your portfolio is properly diversified and you have the proper asset allocation, then you might not be doing yourself a favor by withdrawing your investments. Take control of your emotions and your plan today. Plan for the risk and volatility so you can be in a better emotional state when there are market corrections.
