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 investment decisions?
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 occurrence.
- 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 best performers.
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 predict.
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 runs out.
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 are life-changing.
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 request.
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 anna.bartle@ph.co.nz.
