Rein In Your Caveman Brain

The human brain is hard-wired to survive in the wild. That said, as feral as the stock market has been as of late, our caveman instincts just don't cut it when it comes to making smart investing decisions.

In times like these, our brains are our biggest liability. The ingrained tools that keep us from harm's way -- our drive to seek more and more information, to look for patterns, compare options, and even flee to safety -- are the very same ones that compel us to make boneheaded financial mistakes. Worst of all, often we're not even conscious that we're on a financial suicide mission until it's over.

Warren Buffett agrees: "Success in investing doesn't correlate with I.Q. ... what you need is the temperament to control the urges that get other people into trouble in investing." He's openly admitted that a short in his analytical circuitry in the 1980s cost him $10 billion over time. (More on that in a bit.) That's right: The Oracle of Omaha made a big investing blunder because his brain got in the way.

Investor Psych 101
The good news is that with pointed conscious effort, you can tame your gray matter and neutralize the psychological noise that leads to bad investing decisions. The first step is to recognize the analytical and emotional tripwires we encounter when we're hopped up on money.

Here are a few of the major cognitive biases and some ideas on how to sidestep their devastating forces:

Hindsight Bias: Admit it: You knew the market was going to tank along with Wachovia (NYSE: WB  ) , AIG (NYSE: AIG  ) , and Freddie Mac (NYSE: FRE  ) . Us too! (Ahem.) Through the wonderfully deceptive gift of hindsight bias, past events appear to be much more predictable than they were in real time. The real kicker is that when we look back, we actually believe that we knew what would happen before it did.

The cure: Stop guessing. None of us can predict when the market is going to turn, so stop trying to time it. Instead, focus on your circle of competence -- analyzing the businesses in your portfolio, looking at how they are faring the current market, and seeing whether the fundamentals that attracted you in the first place are still the same.

Myopic Loss Aversion: When things go swimmingly, it's easier to think long-term. But when we're terrified of losing money, our time horizons shrink dramatically. We no longer project what will happen to the business over the course of the next three to five years. Instead, we focus on what happens to the stock price over the next three to five minutes. Think you're immune? Then consider this: When's the last time you plumb forgot to check in on your portfolio? OK, when's the last time you checked it just twice a day?

The cure: Go long. For Fools, investing success is not measured in minutes or even months: We picked our investments for their long-term potential. If you think like a short-term trader, then you'll be tempted to start acting like one. And right now, nothing could be worse for your sanity and your savings.

Information Bias: What would you do when the cable goes out? Probably panic. And if you were tight with the neighbors, you might even head to their house to check and recheck market performance and stock prices over and over and over during the same day. Yet most of that information is totally useless.

The cure: Avoid information overload. Let the Joneses enjoy an uninterrupted dinner: You might be surprised how much better off you are during the three days it takes the cable guy to show up. Watching the market's conniptions and CNBC's pundits breathless banter simply makes the situation seem more dire and puts us at the mercy of our next cognitive bias ...

Social Proof/Herd Mentality: It's easy to assume that when the market drops 18% over the course of the week, "it" knows something we don't. That assumption gains credence as others presume the same. Robert Cialdini, author of Influence: The Psychology of Persuasion, explains how this pile-on takes place: "The greater the number of people who find an idea correct, the more the idea will be correct." So everyone starts selling in a panic -- "The market is going down and I want out first!"

The cure: Ignore "them." Like your mother said, just because everyone else is jumping off a bridge doesn't mean you should. Instead, stick to your plan. Invest on a schedule and tune out the crowd. While everyone else is trying to game the system, you should be on the lookout for the opportunity to buy great businesses with strong balance sheets on sale.

Anchoring: Focusing solely on a number is one of the most dangerous mental hiccups to investors -- and lately we're drowning in a sea of them (stock prices, market indices, etc.). Here's how: Suppose we go to a used car dealership and find a car priced at $7,000 and return later that afternoon to find that it has been marked up to $9,000. Nine grand strikes us as too expensive, even though we know nothing about the actual value of the vehicle. However, had we first seen the car priced at $11,250 and talked the sales person down to $9,000, our mind would tell us that we were getting a great deal. The car is downright cheap! In both cases we anchored on a number -- a completely arbitrary number.

The cure: Anchor on value, not price. Anchoring is devastating in investing terms: Remember, a stock isn't cheap because it was more expensive yesterday or even last year. So rather than anchor on price, anchor on value. Do your research and determine the price you're willing to pay for the company's future earning stream before you look at the stock price.

No, you're not a hypochondriac
Did any, or maybe all, of the mind game scenarios above seem uncomfortably familiar? That's OK. Even the best investors in the world are victims of the most basic cognitive biases.

As we mentioned earlier, the great Warren Buffett -- perhaps the most evolved investor on the planet -- has admitted as much several times in his annual letters. His momentary lapse?: Good ol' "anchoring."

In the 1980s, Buffett nibbled a bit on Wal-Mart (NYSE: WMT  ) at $23. When the stock went up one-eighth of a point, he waited on the sidelines for it to come back to his original price. His "thumb-sucking" reluctance (Buffett's words) to pay even a little more cost him $10 billion in profits.

That's right, even Buffett has to work at reining in his caveman brain.

For more in our "What Investors Should Be Doing Right Now" Special Report:

Andrew Sullivan, Dan Dzombak, Dayana Yochim, Nick Crow, and Wade Michels contributed to this report. None owns any companies mentioned in this article. Wal-Mart is a Motley Fool Inside Value pick. The Motley Fool is investors writing for investors.


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  • Report this Comment On October 28, 2008, at 2:19 PM, spbanalytics wrote:

    OUCH!!!!!! MAKE IT STOP!!!!!

    this article brings back the all to recent and painful 2008 CFA - Level III - Study Session 3 - Behavioral Finance!!!!!

  • Report this Comment On October 29, 2008, at 8:21 AM, TMFMarlowe wrote:

    I'm glad to hear that behavioral finance is part of the CFA now. Personally, I think the basics should be taught in high schools.

  • Report this Comment On October 30, 2008, at 12:55 PM, InFinLit wrote:

    Great book related to behavior: Nudge

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