investor psychology by matthew lekushoff financial advisor [email protected]
TRANSCRIPT
Topics
• Where Did We Come From & Why It Matters
• How Your Brain Responds to Money
• Psychological Biases That Affect Financial
Decisions
• Does Money = Happiness
Know Thyself
Know Thyself
“Know thyself?If I knew myself I’d run away!”
Johann Wolfgang von Goethe
Know Thyself
Where We Come From• Human evolution started 4 to 7 million years ago
• Today’s “modern” human brain appeared 150,000 to 200,000 years ago
• Most of this time we were “hunter-gathers”
• Agriculture was developed about 10,000 years ago
• Means we’ve spent over 99% of our evolution as hunter-gatherers
Know Thyself
• For the vast majority of our species’ time on earth we needed our brains to work a way that is impractical in today’s world
• Fear is our basic emotion. It has evolved to help us anticipate danger and avoid pain
• Fear is fundamental because life is fundamental. If we die, everything else becomes irrelevant
• Social comparison probably served early man well: by observing those who had more, our ancestors learned how to get more themselves. Envy could help someone survive
Know ThyselfWhat This Means For Our Emotions
• Fear or loss is stronger than the anticipation of gain
• We process information through short-cuts and filters to shorten analysis time
• We seek patterns
• We were originally designed to get more of whatever would improve our odds of survival and to avoid whatever would worsen them
• Evolution has designed our emotions “to make us want to do what our ancestors had to do”
Know Thyself
Our Brains Now
• Three Pounds
– Has tripled in size over our history
• 100 Billion Neurons
• Would take 32 million years to count the connections of just the cerebral cortex
How Your Brain Responds to Money
This Is Your Brain On Money
How Your Brain Responds to Money
• The neural activity of someone who anticipates they will make money is indistinguishable from that of someone who is on cocaine or morphine
• Dopamine is involved in the brain's reward and motivation system and in addiction
• High levels of dopamine are believed to increase feelings of pleasure and relieve pain
• Getting what you expect gives you no dopamine kick
How Your Brain Responds to Money
• You need to feel like you deserve the money to get excited
• The anticipation is often better than the achievement
• The longer a sequence has repeated, the more vehemently your brain will respond when the pattern is broken
• Financial losses are processed in the same areas of the brain that respond to mortal danger
Psychological Biases
Psychological Biases
We have seen the enemy……..and he is us!The Pogo Papers
Psychological Biases
Morningstar Survey• Looked at all 17 categories of securities they follow• In all 17 the time weighted returns are higher than the dollar
weighted returns
Top 10 Internet Funds 1997-2002• Time weighted average 1.5%/year• Dollar weighted -72%
• Tax bill was 24% due to turnover
Psychological Biases
• Over Confidence– 82% of students consider themselves better than average
drivers
– Men are more overconfident than women in areas like finance
– Overconfidence leads to too much trading and higher fees as well as taking too much risk
– The closer the odds are to 50/50 the more we become over confident
Psychological Biases
• Pride and Regret (Get-Evenitis)– Selling winners too early and losers too late
- Investors are 50% more likely to sell a
winner than a loser
Solution• Ask yourself: Would I buy this stock if I didn’t own it?
Psychological Biases
Considering the Past• We tend to judge the probability of an event by the ease with
which we can call it to mind
• People tend to use a past outcome as a factor in evaluating a current risky situation
• People take a larger risk after large gains and less risk after loses
• However, sometimes after losing money some investors will "double down" to get even
Turkish Proverb: If you burn your mouth with hot milk, next time you’ll blow on your yogurt
Psychological Biases
Considering the Past
• Purchasing a trip to Hawaii
• Scenario 1– Starts at $2000 then falls to $1600
• Scenario 2– Starts at $2000 falls to $700 then rises to $1500
• This happens with investments regularly
Psychological Biases• Authority
– Be careful what “experts” say• Make sure you don’t follow their advice because you “like” them
– Jim Cramer “Mad Money”– Consider their incentives
• Scarcity– IPOs
– Stocks that are “running”
• Mental Accounting– Viewing investments individually as opposed to part of the whole.
– Portfolio development and construction
Psychological Biases
Representativeness and Familiarity
• Employees owning a high percentage of their company's stock
• Geographical Bias
– Canadians owning mostly Canadian stocks
– Kiwis keep 75% of their investments at home
– Greeks keep 93% of their investments at home
– 17 years ago Japanese investors had 98% of investments at home
– Residents of Atlanta owning lots of Coke
• Over 50% of the time an investor becomes interested in a stock because another person mentions it
Psychological Biases
• Social Proof– Herding
• Buying Nortel because everyone else owns it
– Leads to bubbles and crashes
• Mood– Compared the daily return in 26 stock exchanges around the
world to the weather in the 26 exchanges.
– When they annualized the difference between the sunniest and worst days the difference was 24.6%
Does Money = Happiness?
Money & Happiness
“Wealth is like sea-water: the more
you drink, the thirstier you become”Arthur Schopenhauer
Money & Happiness
There is little correlation between money and happiness
• Two notable exceptions:– People below poverty line– People who put a very high value on money
• Its not that money can’t buy happiness. Its that once you have enough to meet your basic needs, more money buys much less extra happiness than you think it will.
Money & Happiness• Bernoulli's Gift (1738)
• Expected Value = (Odds of Gain) X (Value of Gain)
• We are very poor estimators of what will make us happy
Question – Which of the follow two things would you rather have happen?
• Option 1 - Win the lottery
• Option 2 - Become a paraplegic
Anticipation is often very different to eventual feeling
Money & Happiness
What makes us happier?– Strong social ties
– Living in a society with low corruption
– Wealth (Not nearly as much as we think)
– Being gratitude for what you have
– Being optimistic
– Exercising
– Having someone in your life to share your stresses, crisis and tragedies with
– Getting older
Money & Happiness
What makes us unhappy?• Comparing poorly to peers
• Little social support and contact
• Envy
Money & Happiness
• Financial Planning– Risk Management– Retirement Planning– Estate Planning– Tax Planning
• Life Planning– Goals– Holidays– Social Events– Property– Education
Conclusion
Conclusion
• Keep in mind the psychological biases we are pre-disposed to
• Don’t buy stocks or investments. Build a portfolio
• Avoiding the big mistake is the most important thing
• Having a well thought out plan is essential in order to reach your goals and get the most out of your life
• Make and follow rules
Recommended Readings/Research
• Stumbling on Happiness– Daniel Gilbert
• The Psychology of Investing– John R. Nofsinger
• Your Money & Your Brain– Jason Zweig
• Influence: The Psychology of Persuasion– Robert Cialdini
• Seeking Wisdom – From Darwin to Munger– Peter Bevelin
• Ted.com– Daniel Gilbert– Barry Schwartz
