The subject of human behaviour is fascinating but when it
comes to investment behaviour it can be alarming.
So why do clever, successful people often make lousy
In short, it is because our brain is hard-wired to react
instinctively to a challenge.
Our brains are incredible instruments, especially when our
responses need to be rapid, but they are less useful when it
comes to making long-term investment decisions.
Many interesting experiments show us repeatedly making the
wrong choices. This article addresses our compulsion for
prediction. In short, we have a prediction addiction and we
see patterns even when none exist.
In a typical experiment of its kind, humans are exposed to
random flashes of red and green lights and are rewarded if
they can predict the correct colour before it is flashed. The
green light is flashed 80% of the time and red 20%.
Rats and pigeons quickly learn that green is the best bet
every time given that the short-term pattern is random and at
least they get it right 80% of the time.
Not so, humans. People tend to see patterns even when they
are told that the lights are flashing randomly and this
misguided confidence leads them to accurately pick the colour
only 68% of the time, on average.
''Unlike other animals, humans believe we're smart enough to
forecast the future even when we have been explicitly told
that it is unpredictable,'' writes financial author and
journalist Jason Zweig.
According to psychology professor George Wolford, of
Dartmouth College, in the United States, there appears to be
a module in the left hemisphere of the brain that drives
humans to search for patterns and see causal relationships.
Mr Zweig summarises the research:
- We leap to conclusions - when faced with two of almost
anything in a row, we will expect a third identical
- It happens unconsciously - We don't know we're doing it.
- It happens automatically - We always do it.
- It is uncontrollable - We can't turn the processing off.
This makes us hugely vulnerable when it comes to investment.
No matter how many times we are told that past performance is
not a good guide to future performance, we look to the recent
For many of us, it is only when we think we have found a
pattern in past returns that we feel brave enough to invest,
yet 99 times out of 100 there is no pattern, especially in
the short term.
There are many reasons why prediction (or forecasting) is
unlikely to produce superior returns and here are a few:
1. The market price already represents many different views
on an investment and although it is not always right in
hindsight, the degree to which it is wrong is not easy to
2. Random events overtake us in the economy, with trade
problems, inflation scares, war, weather etc
3. A prediction can be right by pure luck, and then your luck
4. We can predict correctly, but get the timing wrong. We
have been forecasting interest rates to go up since early
2011 and it hasn't happened yet.
5. A correct prediction on its own isn't much use. One
usually has to get several things right in a row to profit
and the difficulty increases with each prediction.
6. It costs money to change anything in the investment world
and this raises the bar. A prediction has to be even more
successful to justify the cost.
Oh dear. What can we do to minimise the impact of our
compulsive desire to predict?
Here are some:
1. Prepare, but don't predict.
2. Forewarned is forearmed. Study and read.
3. Manage your expectations.
4. Take your time. Take a break before making investment
decisions. Twenty minutes will do for little decisions,
overnight for bigger ones, and take a year when the decisions
5. Ask for evidence when people make claims to tempt you and
change the time frame on them.
6. Put your investing on auto-pilot, (we call it dollar-cost
averaging), like you do with KiwiSaver.
7. Diversify. Expect to have sectors in your portfolio that
are doing poorly while others are doing well.
8. Don't count your money too often; it will make you
miserable as temporary losses weigh heavily on your brain.
Rhodes Donald is director and senior adviser for Polson
Higgs Wealth Management Ltd. Disclosure document available on
As part of Money Week, Mr Donald is addressing this
topic at a free public seminar, ''Investing and the Behaviour
Gap - why our natural instincts let us down'' at 1.15pm
tomorrow, Dunningham Suite, Dunedin City Library. To book,
phone (03) 474-9709 or email email@example.com.