Behavioural finance: Emotions

October 2014

Ever heard of the amygdala? It’s the part of our brain that governs subconscious responses to, and memories of, fear, pleasure and pain. Evidence suggests the amygdala, essential to our day-to-day survival, is terrible at making investment decisions.

The problem is that faced with complexity, rather than think more about an issue, we tend to back our instincts when making a decision. Our subconscious desire to avoid losses and to shun making a decision we might regret are two of the most common hurdles to overcome in investing.

From experiments based on gamblers, scholars have found that the pain of losses is around twice as much as the pleasure associated with equivalent gains.

If we combine this aversion to losses with our ability for creative mental accounting, we have a recipe for investing disappointment. If one investment in our portfolio, for example, is showing a 5% loss and another is showing a 5% gain, we should be delighted to have spread our bets. If we need to draw down some money from our portfolio, we sell the loser and we are no worse off, right?

In reality, it’s not that easy because selling the loser involves crystallising a loss in our mental account, and everything in our sub-conscious brain is telling us to avoid losses. The evidence from behavioural finance suggests we are more likely to sell the winner. Despite the fact we have an offsetting gain, we just cannot bring ourselves to sell the losing investment. Called the disposition effect, this is a serious problem in investment where it is impossible to be right all the time.

More work is being done around people’s responses to losses. There is evidence to suggest that people become risk-seeking to get a crystallised loss back and when their options are bad. Informal observations of groups suggest that a “three strikes and you’re out” form of subconscious thinking can kick in when investors experience a series of losses.

This suggests people may ride out the first correction in the stock market, then painfully hold on during a second before capitulating on about the third correction. Unfortunately, stock markets often seem to have a few corrections even if they are recovering. Indeed, this is a central observation of the Elliot Wave theory of corrections in stock markets, where three downward waves are interspersed with two smaller consolidation waves in a five-part cycle. The unfortunate irony, then, is many investors are being primed by their subconscious thinking to sell at the wrong time. It’s best to think, rather than feel, with investing.