There are innate natural tendencies that have kept us alive for thousands of years that predispose us to naturally not be wired to be successful investors. These tendencies are in all of us including Warren Buffet.
Our brains simply aren’t hardwired for investing, but this in no way means be cannot succeed at investing, it just means we need tools to help us overcome this hardwiring.
Knowledge Doesn’t Equate with Investment Success
Many would-be investors are convinced that if only they had more knowledge and information, they would be far more successful at investing. Others believe their starting capital is too small.
The reality, though, is that no matter how much starting capital one has, or how knowledgeable they are, if they don’t use tools to overcome our natural hardwiring, they can still fail.
Consider Martin’s situation. He graduated with a degree in economics and finance and went to work as a financial analyst for an investment bank.
Even though he had the know-how and could analyze the fundamentals of a stock in his sleep, he was still susceptible to these natural tendencies that lead to failure. He’d even started his investment journey with a healthy capital thanks to the fact that he was single, lived a relatively simple lifestyle, and had a nice salary.
He applied the same analytical principals from work to his investments, yet he was still significantly underperforming the markets.
He knew his technical know-how wasn’t to blame. His bosses constantly praised his analytical skills and good calls at work. So, why wasn’t he able to replicate the results for himself?
One day at work, his direct manager, John, asked him to attend a lecture on investment behavior and psychology. He was a little stumped. He was an analyst, not a psychologist. What could possibly be the point?
John explained to him that the company had decided all employees had to attend the course so they could better relate to their customers and understand their decision-making process.
Martin nodded, knowing he had little choice but to attend, even if he still didn’t see the point.
However, once the lecture started, Martin’s interest was piqued though he was still a little skeptical. Richard, an economist and professor explained that through his research he had been able to prove human behavior was the biggest obstacle to success for most investors.
As the lecture wore on Richard not only supplied compelling examples, but also supporting research, Martin had to concede that there might be something to all this “psychology” stuff.
After the lecture, he started implementing what he’d learned in the lecture and it wasn’t long before his so-called “luck” completely changed. He was finally making a nice profit and growing his wealth.
So, what did Richard say that helped Martin turn his fortunes around?
Why Humans Don’t Make Good Investors
According to a Dalbar study, namely the Quantitative Analysis of Investor Behavior 2018, the average investor experienced average yearly returns of about 4% less than average yearly returns of the S&P 500 index.
So, why the poor results?
The first reason is purely physiological. Humans have survived to this day and age thanks to our instinctual acute stress response, more commonly known as “fight or flight.”
When confronting anything we perceive as dangerous, the almond shaped part of our brain called the amygdala located in the temporal lobe of our brain interprets what we’re seeing and sends a distress signal to another part of the brain called the hypothalamus. The latter activates the sympathetic nervous system, which leads to a number of changes in the body to prepare us to be better able to fight or run away.
This stress response is one of the reasons we’re still around today. Otherwise, we’d have long ago been wiped out by the many predators that roamed the earth.
Even today, this natural defense mechanism is still invaluable. After all, it’s what will get you jumping out of the way of an oncoming car, or avoiding dark alleys, and so on.
However, the same response works against you when it comes to becoming an effective investor. This is because of what we fear when it comes to investments.
Generally speaking, what drives investment behavior is 2 different types of fears. The first is fear or missing out also called FOMO and the second is fear of loss. So, when you’re investing, you fear not being part of an upmarket; and when markets are declining, we tend to want to sell to avoid losses. The result is erratic behavior as your acute stress response kicks in and your brain is in fight-or-flight mode, which can throw rational thinking out the window.
But there’s another issue we have: Humans live under the mistaken belief that we can be completely rational at all times. In fact, it was proven as far back as 1974 that humans are actually pretty irrational and don’t weigh decisions carefully before making them as often as we think.
In certain situations, this was considered a good thing. Unfortunately, when it comes to investing, making rational decisions is paramount to success.
Even culturally, we seem to have set ourselves up to fail. Normally, if a sale is on for something we like, we’ll buy more of that item. In fact, some people buy stuff they don’t even need just because the price has dropped. However, when it comes to investing, we tend to avoid buying when prices drop and buying as prices are rising instead of the other way around.
Of course, as many successful investors have proven, we can get around these physiological, psychological, and cultural barriers. Here are two tools that can help.
Tools to Help You Succeed at Investing
Martin put his pride aside and accepted that no matter how smart and knowledgeable he was, the obstacles he faced would never just disappear. After all, it’s not like he could suddenly eliminate his instincts. So, he followed Richard’s advice to use certain tools that would allow him to succeed.
The first was the most important. He developed a goals-based financial plan. When he first started out, Martin didn’t have a clear goal. He just knew he wanted to make money. Richard advised him, though, to establish specific goals and then create a plan on how he’d achieve those goals.
So, instead of the generic “making money”, Martin’s new goal was to create a portfolio that would generate inflation-protected, after-tax income that would allow him to enjoy a long retirement with a comfortable lifestyle.
Once he had his plan in place, he found it much easier to make rational decisions. Every time he was tempted to make an emotional decision, he’d simply look at his plan again and he was reminded of why he was doing what he was doing. It was incredible how focusing on a specific goals enabled him to make more rational decisions.
The second tool was to put aside his tendency to research and invest in a small group of concentrated stocks and instead to build a properly diversified investment portfolio that was spread out by asset class, geography, and investment style. Basically, it was the principle of not putting all his eggs in the same basket.
The results were quick to follow. A diversified portfolio helped Martin mitigate some of the volatility that would occur with different asset classes. Though temporary, Martin’s prior approach would often lead him to rush out of the market when the volatility occurred because of a lack of diversification.
Knowing that his investments were diversified and none of his individual stocks represented a significant portion of his portfolio also meant that Martin didn’t check in as frequently, so he was far less likely to make impetuous decisions driven by fear.
Overcoming your hardwiring is almost impossible unless you have the right tools. A goals-based financial plan will allow you to keep your ultimate objective front and center, which will make it easier for you to bypass the wiring that would have you making irrational decisions.
Essentially, it reminds you what you’re fighting for, and when you have something to fight for, it’s far easier to push down the fear.
By diversifying your portfolio, you are reducing temporary volatility, which is one of the biggest drivers of fear when investing. When you know you’re portfolio is less risky, your acute stress response won’t be triggered because it doesn’t have a reason to.