SERIOUS MONEY:TO SUCCEED in the uncertain world of investment, intelligence alone will not suffice; self-awareness and emotional well-being are also necessary. As the American economist George Goodman once quipped: "If you don't know who you are, the stock market is an expensive place to find out."
Unfortunately, too many investors yield to emotional cues that damage investment performance. Colin Camerer and George Loewenstein, two noted experts in the new field of neuroeconomics, observe that “the mind is a charioteer driving twin horses of reason and emotion. Except cognition is a smart pony, and emotion an elephant.”
Value investing is a proven strategy over long horizons, yet all too often investors dismiss the historical evidence and chase short-term returns instead. Investors follow the crowd and buy into momentum stocks at inflated prices – a sure road to penury.
Why do investors consistently engage in such self-defeating behaviour?
Warren Buffet, the renowned value investor, in his letter to Berkshire Hathaway shareholders in 1988, wrote: “Our favourite holding period is forever.”
Unfortunately, for many investors, the desire for immediate rewards means holdings considered long-term in nature are often short-term positions gone awry. Economist, John Maynard Keynes once observed: “It is a leading fault of all institutional investors that their portfolio gradually tends to contain a long list of forgotten holdings originally purchased for reasons which no longer exist.”
The human brain is hardwired for immediate rewards and can delay gratification for little more than a few minutes. The pursuit of reward is one of the primary goal-oriented systems in the brain and is often associated with impulsive emotional responses that can cause investors to disregard their long-term objectives in pursuit of instant gratification.
The archetypal experiment reveals that most human beings would prefer to receive € 100 now over € 110 in a week, yet would choose € 110 to be received in a year and a week over € 100 in one year. This implies that humans engage in hyperbolic discounting, with a disproportionate preference for instant rewards. In fact, the discount rate required to delay immediate rewards has been measured at 40 per cent, while the discount rate for long-term rewards is roughly 4 per cent.
Samuel McClure, a neuroeconomist at Princeton University, investigated this anomaly through the use of functional magnetic resonance imaging on volunteers. Anticipation of an imminent reward triggered activity in the “emotional” limbic system and the subsequent release of dopamine – the “pleasure” chemical – often overwhelmed higher reasoning, as attention is directed towards the attainment of the desired goal.
The contemplation of long-term rewards activated the “rational” pre-frontal cortex, which enabled subjects to defer gratification. Importantly, McClure observed that subjects’ choices were directly related to the relative amount of activity in either part of the brain.
Hyperbolic discounting alone is not sufficient to explain investors’ indifference towards value investing, but the inability to delay gratification combined with an instinct to recognise patterns – even when none exist – adds fuel to the debate. Scott Huettel, a Duke University neuroeconomist, discovered the subconscious brain begins to expect repetition after a stimulus is observed just twice. Thus, investors expect future performance to mirror past returns and buy into the “hottest” stocks with little fundamental justification.
The tendency to anticipate the future based on a handful of recent observations conserves scarce neural resources, but can it also give rise to self-defeating behaviour, as the brain recognises patterns in random events. A simple experiment has been conducted on humans, pigeons and rats, where two lightsare flashed on to a screen. The green light is flashed 80 per cent of the time and the red light the remainder, though the sequence is random. Subjects are rewarded if they correctly guess the colour of a flash.
The rational strategy is to guess green every time, which is exactly what rats and pigeons do as the experiment proceeds. Humans, however, typically select green four times out of five, as the brain begins to anticipate a pattern in the random sequence.
Confidence in their predictive ability sees humans lag the performance of the rats and pigeons, with correct guesses occurring less than 70 per cent of the time. Is it any wonder that investors purchase momentum stocks at inflated prices? A further factor that precipitates return-chasing behaviour is the innate desire to be part of the crowd. A contrarian value strategy is not an attractive biological proposition for most investors.
The world’s most successful investors have typically earned their reputation through a value strategy, though most novice and professional investors engage in dangerous return-chasing behaviour. Buffett once said: “Success in investing doesn’t correlate with IQ once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” Readers should take note.
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