The year our banks (and our emotions) went into lockdown.

Are your investments at the mercy of your emotions?

It goes without saying that 2020 was an extraordinary year. The devastation caused by a microorganism has served as a reminder to us all to not take things for granted. All of us have been affected by the impact the pandemic has had on our everyday lives and many of us have altered our focus on things that ‘really matter’, rather than allowing more trivial things to upset us.

Of course, what matters to one person is very different to another and in some instances it takes a conscious effort to suppress some of the emotional responses we feel and act on. The ability to take stock and apply a more logical thought process can be one way forward, but years of evolution have affected how our emotions influence our decision-making process.

 

 

We have evolved with the ability to make quick decisions based on limited information and we all experience this on a regular basis. We have at some point found ourselves in a situation where we are required to act immediately to what we perceive to be a potential threat or danger. A common example of this is whilst driving and having to make an emergency stop:  pure reflex reaction in response to an unexpected situation. What a skill!

 

 

The emotional evolution – can our behaviour lead to poor investment choices?

It’s not often we think about how this ‘skill’ has come about and is generally something we all take for granted, but the reality is that this ability has been developed over years of evolution. It has played a major role in helping us get to where we are today! Although, it is worth taking into account that evolution occurs at a snail’s pace and our brains may actually be better designed to cope with the environment humans faced many thousands of years ago, and rather less suited to the technology-driven information age we currently live in.

 

 

Our ability to make quick decisions based on limited stimuli and information has been a vital survival tool throughout our existence. However, evidence suggests that the psychology behind this can actually lead us to make poor decisions, particularly in the modern world, where we are required to process complex information, sometimes in haste. Our natural inclination is to respond to this task using a similar response to the way we dealt with the driving incident – it may not be a case of slamming on the brakes but invariably a case of ‘the quick fix’. Similarly, this ‘slick’ decision making process is often employed by the brain when dealing with our investment choices. Some of the more traditional finance theory makes the assumption that investors are rational and make optimal decisions all of the time but experience has shown us that this is not the case! More recently, the field of behavioural finance has attempted to understand how investors really make decisions and how their inherent biases affect their choices.

 

 

How do investors make decisions?

Psychologists have suggested that the best method of thinking about how choices are made is to imagine our brain uses two different systems to come to a decision.

 

 

The first is essentially an emotional approach which is actually our default option. It is automatic and effortless making judgements on aspects such as similarity, familiarity and proximity (in time) e.g. Slamming on the brakes! This ‘short cut’ system enables us to process large amounts of information simultaneously and provides answers that are approximate, rather than precisely correct. (One of the pitfalls of this system is that to believe something is valid, it may simply need to wish it were so.)

The second system is the more logical way of processing information and requires deliberate effort to actually engage it.  This route follows a deductive, logical approach to problem solving as it can only handle one step at a time. Consequently, this system is slower ( the cogs are turning albeit a tad rusty!) and uses a sequential way of dealing with information, but both evidence and logic are needed to believe that something is true.

 

 

Are you emotional or logical?

Most of us like to think we use a logical approach to our decision making, but research¹ suggests our short cut system deals with far more decisions than we would be comfortable to admit. Apparently, we very often end up trusting our initial emotional reaction and only occasionally do we end up using our logical system to review our decisions. Neuroscientists have found that the parts of the brain associated with the emotional system is much older, from an evolutionary perspective, than the parts of the brain associated with the logic system. We clearly developed the need for emotional responses, likely to do with survival instincts, before the need for logic.

 

 

Test your investment brain!

From an investment perspective we are likely to gain the most benefit from using the logical approach. A simple three question test was designed to see how good we are at measuring the ability of our logical system to evaluate the quick conclusions made by our short cut, emotional system. This test is known as the Cognitive Reflection Task (with the answers at the bottom of the article – but no cheating!).

 

 

 

The questions are:

1. A bat and a ball together cost £1.10 in total. The bat costs £1 more than the ball. How much does the ball cost?
2. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?
3. In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

Each of these questions has an obvious, but incorrect answer, and a less obvious correct answer. This simple test shows us that we are all prone to decision making using our emotional short cut system which can often remain unchecked by our more logical system.

The relevance of this from an investment point of view is to understand when we are most likely to rely on our emotional decision-making response and leave this unchecked by our logical process.

 

 

Decisions, Decisions

Research shows that the following conditions are likely to increase the reliance on our emotional thinking:

• When a problem is poorly structured and complex.
• When information is incomplete, ambiguous and changing.
• When the goals are ill defined, shifting, or competing.
• When stress is high, because of time constraints and/or high stakes are involved.
• When decisions rely on the interaction of others.

 

 

We can all identify with these in our daily lives and you can appreciate how these are very relevant to many of the decisions we make concerning our investments. There has been a great deal of research into the biases affecting our investment decision making (but we thought we’d save that for a future edition.)

 

 

Men vs Women: Who makes the best investment choices?

Research² detailing the transactions of 66,000 investor trading accounts were analysed over a five year period and it revealed some interesting results. Firstly, the study showed that men were more likely to be over-optimistic than women. Secondly, men were also more likely to be over-confident.

This was an important factor in both the volume and frequency that these investors traded their investments (often referred to as ‘turnover rate’) with men, on average, having an annual turnover rate of 77%. Women, on the other hand had a much lower annual turnover rate of 53%.

On average those that traded most frequently produced the lowest returns with annual net returns (after costs) being 6% lower than those that traded less frequently. Taking these things into account its unsurprising that women ended up with higher net returns. Furthermore, accounts where men needed their wives’ permission to trade performed better than single men. And to top it off, women that needed their husband’s permission to trade underperformed single women. Meaning not only can men be bad traders, they can be a bad influence as well!

 

 

How does a financial adviser help?

Understanding these biases is where our industry adds significant benefit. The structures and processes we have in place are to help avoid some of the pitfalls brought about by our behavioral biases.

 

 

As financial planners we take a great deal of time to understand each client’s situation and construct realistic plans to help them achieve their objectives in the most efficient way possible. We look to develop strong long-term relationships to cater for the changes in circumstances that life brings. All plans, no matter how good or robust need to be regularly reviewed and adjusted where necessary, with the focus targeted on meeting the desired outcome. An essential part of this is ensuring your protection needs, pensions and investments are well managed and that any decisions concerning these, investment or otherwise, are taken after due care and consideration.

The way we have evolved has helped  to shape the way in which we respond to certain situations and none of us are immune from the consequences that rash or poor decision making can have on our circumstances. Looking at the list mentioned above you can appreciate how we help with some of the complexities our clients are faced with when dealing with their finances. We really do help with these and like most industries, a great deal of the work goes on under the radar. This often goes undetected but is a fundamental component in our efforts to achieve the best outcome possible for our clients.

 

 

 

How did you do in the logic test?

In question 1 the quick ‘go to’ system wants us to go for 10 pence. However a little logic confirms that the bat has to cost £1 more than the ball, if the ball cost 10 pence the bat would cost £1 and only be 90 pence more than the ball. Therefore the ball must cost 5 pence and the bat cost £1.05. So the answer is 5 pence.

In question 2, the gut reaction is to say 100 minutes. With some reflection we can see it takes 5 machines 5 minutes to produce 5 widgets. The output is one widget per machine every five minutes. Therefore it would take 100 machines 5 minutes to make 100 widgets. Answer is 5 minutes.

In the final question the most common answer is to halve the 48 days and say 24 days. As the lily patch doubles in size every day, the day before it covers the entire lake, it must have covered half the lake. Making the answer 47 days.

If you got some of these questions wrong you’re not alone. Out of nearly 3,500 participants taking the test a third (33%) didn’t get any correct answers. Only 17% managed to get all three questions right. There are many investment biases to consider and the study of these can have an effect on our investment arrangements. Feel free to contact your financial advisor for further information.

 

             Lloyd & Whyte, what matters to you, matters to us.

 

 

1. The Little Book of Behavioral Investing by James Montier
2.  Trading Is Hazardous to Your Wealth – The Common Stock Investment Performance of Individual Investors by Terrance Ogden & Brad M. Barber