The Role of Habits in Investing

"All our life ... is but a mass of habits ... bearing us irresistibly toward our destiny."
-- William James

Seven years ago, a researcher at Duke University found that more than 40% of the actions people perform each day aren't the result of conscious decisions. They're dictated instead by habits. As a result, if you want to get better at something -- in our case, investing -- then this is probably a good place to start.

Most of us are habitually bad investors
I think we can all agree that most investors (myself included) have a multitude of bad habits, and that those habits have a detrimental impact on our returns. I'm referring most specifically to the tendency to think short-term, obsessively check stock quotes, and succumb to fear when the market is down and to euphoria when it's up.

You've heard it a million times before: Frequent trading in and out of stocks is bound to produce subpar, if not negative, returns. The evidence is convincing, if not unequivocal. Yet online discount broker TD AMERITRADE (NYSE: AMTD  ) announced earlier this week that a full 10% of its customers' trades were done on mobile devices -- implying a sense of urgency that isn't typically associated with long-term investing.

So why do we do this? According to Charles Duhigg's exceptional book The Power of Habit, "Particularly strong habits ... produce addiction-like reactions so that 'wanting evolves into obsessive craving' that can force our brains into autopilot, 'even in the face of strong disincentives, including loss of reputation, job, home, and family.'"

A study cited by Duhigg drives this point home. In response to cues, such as the ringing of a bell, researchers trained mice to press on a lever in exchange for food. Once the habit was ingrained, the food was laced with a substance that made the mice violently ill. The researchers were trying to determine whether the mice would continue to eat the food despite the adulteration.

What do you think happened? As one might expect, the mice quickly learned to avoid the food when it was presented to them in a bowl. Yet when they were confronted with the ingrained cue from before, they couldn't stop themselves from pressing on the lever and eating the food.

The link between mice and humans may seem tenuous at first. But upon deeper reflection, it becomes obvious that the human world is replete with evidence of analogous behavior. As Duhigg points out:

Consider fast food. ... It makes sense -- when the kids are starving and you're driving home after a long day -- to stop, just this once, at McDonald's or Burger King. The meals are inexpensive. It tastes so good. After all, one dose of processed meat, salty fries, and sugary soda poses a relatively small health risk, right? It's not like you do it all the time.

But habits emerge without our permission. Studies indicate that families usually don't intend to eat fast food on a regular basis. What happens is that a once-a-month pattern slowly becomes once a week, and then twice a week -- as the cues and rewards create a habit -- until the kids are consuming an unhealthy amount of hamburgers and fries.

Thus, to reiterate the point, certain habits are so strong that they "cause our brains to cling to them at the exclusion of all else, including common sense."

How to fix bad investing habits
How many times have you heard somebody say that they need to eliminate this or that bad habit? My guess is: many times. And if you're anything like me, you've probably said it yourself on more than one occasion.

It turns out, however, that this is the wrong way to think about the issue. Much like the data on an old disk drive, studies show that bad habits never go away, or at least not entirely. Instead, they can only be overwritten by better ones. Psychologists refer to this as "habit reversal" -- sounds Orwellian, I know.

A habit can be broken down into three distinct parts, which together form a "habit loop." First is the cue, which triggers your brain to initiate the loop -- say, watching CNBC or reading an alarmist headline. Next is the routine, which consists of the behavior itself -- for instance, selling a stock in panic based on what you just learned. And finally is the reward -- in our case, the rush of relief that comes over you after the trade.

With this in mind, the objective isn't to eradicate the entire habit loop, but rather to identify the cues and rewards and then swap out the undesirable routine for a new one. "That's the rule," Duhigg explains, "if you use the same cue, and provide the same reward, you can shift the routine and change the habit."

So how does this translate into better investing? If there's one thing we know for certain, it's that frequent trading is, to put it in the words of the seminal study on the issue, "hazardous to your wealth." As the authors show, investors who traded the most ended up underperforming the S&P 500 (SNPINDEX: ^GSPC  ) by more than six percentage points per year.

"That's a staggering amount," my colleague Morgan Housel pointed out. "Over time, it's the difference between a good retirement and no retirement."

The trick, in turn, is to trade less frequently. One way to do so is to avoid cues that lead you to do so -- watching CNBC, for example. The other way, as I've discussed, is to swap out the old routine in favor of a new one -- that is, use habit reversal techniques.

I recommend the latter. And, more specifically, I recommend that you bookmark this article on discipline and successful investing and reread it as your routine every time you're confronted with a cue to impulsively buy or sell a stock. I can almost guarantee that doing so will save you money and increase your returns.

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  • Report this Comment On July 29, 2013, at 12:09 PM, foolishlymeek wrote:

    John, I love articles that incorporate psychology with investing. However, I was a bit disappointed with your "swap" of reading your article instead of trading a stock.

    I can think of several "bad" habits to exchange for for the routine of selling stock. You could even incorporate your favorite stocks into your habit. For example, you could eat fast food (MCD, BWK, WEN) or shop online (AMZN, EBAY).

    Or, you could exercise in your favorite Nike sneakers, increase your endurance, and get some good endorphins. In the long run, you would increase your overall health and have an additional six percentage points in your portfolio!

  • Report this Comment On July 29, 2013, at 1:53 PM, JohnMaxfield37 wrote:

    foolishlymeek,

    Your points are well taken. But just for the record, the article I encourage people to read (the one linked to at the bottom) isn't one of mine, but rather by a colleague who discusses the importance of patience in investing.

    John

  • Report this Comment On July 30, 2013, at 5:20 PM, foolishlymeek wrote:

    Thank you, John! I just read "I recommend that you bookmark this article . . . and reread it as your routine . . . ." and didn't see the hyperlink. Old Eyes! :)

    Donna

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