“A bowl of fishballs and noodles cost $1.10. The fishballs cost $1.00 more than the noodles. How much does the bowl of noodles cost?"
If you thought the bowl of noodles cost $0.10, don’t feel bad. (The correct answer is $0.05 for the noodles and $1.05 for the fishballs). Nobel Laureate Daniel Kahneman discovered that more than 50% of students at Harvard, Princeton and MIT gave the wrong answer.
Kahneman’s research shows that humans are constantly frustrating for economists - we don’t act like rational beings and follow their models. Our immediate reaction to situations is not based on a careful evaluation, but rather mental shortcuts formed by our cognitive biases.
The truth is, we’re just naturally wired to be bad at investing. According to Jason Zweig, who published a book on how the brain affects financial decisions, financial losses are processed in the same area of the brain (the amygdala) that responds to mortal danger. You get the same primal ‘fight or flight” reactions: your heart races, your breath quickens and you break out in a sweat. Even the expectation of losses can set off bursts of activity in the amygdala, and the more frequently you’re told you’re losing money, the more active the amygdala becomes.
Watching your investment portfolio fall in value can have a longer-term impact psychologically, and as a result, affect your investment plan. When you have a losing streak, it activates the hippocampus, a part of the brain next to the amygdala that programs our memories of fear and anxiety.
Research from Cambridge also shows that when we have higher levels of the stress hormone cortisol, our risk aversion spikes. Risk takers will exhibit risk averse behaviour during periods of high market volatility, and act in the opposite manner of what a rational investor should be doing. This could explain the ‘irrational pessimism’ during financial crises.
We feel the pain of a loss twice as much as the joy of an equivalent gain. Our basic instincts, which served us well as hunters and gatherers, don’t necessarily have the same benefits today:
- During our caveman times, anyone who underestimated a risk would have made a quick snack for a carnivorous predator. However, no harm would have come to you if you reacted quickly and climbed up a tree when you thought you saw a lion in the distance, even if it turned out to be a false alarm.
- In the world of investing, if you panicked every time your investments dropped and liquidated your portfolio, you would have caused serious harm to your long-term returns.
We are wired to be irrational investors because our ancestors survived on the same mechanisms. Unfortunately, it is hard to kick a 100,000-year-old habit when playing the stock market. We naturally struggle to separate primal emotions from our investment decisions.
Having a long-term, well thought out investment strategy will give us the best chance of overcoming our human impulses, shifting investment decisions from our primal to modern brain (the frontal cortex) responsible for problem-solving, memory, judgement, and reasoning. This will give us the highest probability of success in reaching our financial goals.