To succeed in the uncertain world of investment, intelligence alone will not suffice; self-awareness and emotional well-being are also necessary. As the American economist, George Goodman once quipped, “If you don’t know who you are, the stock market is an expensive place to find out.” Unfortunately, too many investors yield to emotional cues inherited from their ancestral past in the African savannah 200,000 years ago, that can damage investment performance. Colin Camerer and George Loewenstein, two noted experts in the new field of neuroeconomics, observe that, “The mind is a charioteer driving twin horses of reason and emotion. Except cognition is a smart pony, and emotion an elephant.”
Value investing is a proven strategy over long horizons, yet, all too often, investors dismiss the historical evidence and chase short-term returns instead. Investors almost helplessly follow the crowd and buy in to momentum stocks at inflated prices – a sure road to penury. Why do investors consistently engage in such self-defeating behaviour?
Investors’ tendency to exhibit return-chasing behaviour can be traced to the instinctive desire for instant gratification. Warren Buffet, the renowned value investor, in his letter to Berkshire Hathaway shareholders in 1988, wrote that, “Our favourite holding period is forever.” Unfortunately, for many investors, the desire for immediate rewards means that holdings considered long-term in nature are often short-term positions gone awry. Indeed, the economist, John Maynard Keynes, observed many decades ago that, “It is a leading fault of all institutional investors that their portfolio gradually tends to contain a long list of forgotten holdings originally purchased for reasons which no longer exist.”
The human brain is hard-wired for immediate rewards and can delay gratification for little more than a few minutes. Reward-seeking is one of the primary goal-oriented systems in the brain and is often associated with impulsive emotional responses that can cause investors to disregard their long-term objectives in pursuit of instant gratification.
The archetypal experiment reveals that most human beings would prefer to receive €100 now over €110 in a week, yet would choose €110 to be received in a year and a week over €100 in one year. This implies that humans engage in hyperbolic discounting, with a disproportionate preference for instant rewards. In fact, the return required to delay immediate rewards has been measured at 40 per cent, while the discount rate for long-term rewards is roughly four per cent.
Samuel McClure, a neuroeconomist at Princeton University, investigated this anomaly through the use of functional magnetic resonance imaging (fMRI) to detect volunteers’ brain activity. He observed that anticipation of an imminent reward triggered activity in the ‘emotional’ limbic system, which is well-known to release dopamine – the brain’s ‘pleasure’ chemical – a powerful biochemical that can overwhelm higher reasoning – and the sensations produced saw many subjects succumb to instant gratification.
Meanwhile, the contemplation of long-term rewards activated the ‘rational’ pre-frontal cortex, which enabled some subjects to defer gratification. Importantly, McClure observed that subjects’ choices were directly related to the relative amount of activity in either part of the brain. Subsequent studies have confirmed that when the two neural systems are in conflict, the ‘emotional’ limbic system usually triumphs.
Hyperbolic discounting alone is not sufficient to explain investors’ indifference towards value investing, but the inability to delay gratification combined with a hard-wired instinct to recognise patterns – even when none exist – adds fuel to the fire. Scott Huettel, a neuroeconomist at Duke University, discovered that the subconscious brain begins to expect repetition after a stimulus is observed just twice in a row. Thus, investors often expect future performance to mirror recent returns and buy in to the ‘hottest’ stocks with little fundamental justification.
The human tendency to anticipate the future based on only a handful of recent observations conserves scarce neural resources, but can it also give rise to self-defeating behaviour, as the brain recognises patterns in random events. In this regard, a simple experiment conducted separately on humans, pigeons, and rats, whereby the experimenter flashes two lights – one green and one red – onto a large white screen, and subjects are rewarded if they guess correctly the colour of each flash, reveals the futile nature of human prediction.
The experiment is designed such that the green light is flashed 80 per cent of the time and the red light the remainder, though the true sequence of flashes is random. The rational or value-maximising strategy in this game is to guess green every time, which is exactly what rats and pigeons do.
Humans however, typically select green four times out of five, as the brain begins to anticipate a pattern in the random sequence. Confidence in their predictive ability sees humans lag the performance of the rats and pigeons, with correct guesses occurring less than 70 per cent of the time. Is it any wonder therefore, that investors purchase momentum stocks at inflated prices?
A further factor that precipitates return-chasing behaviour is the innate desire to be part of the crowd. The instinct to seek safety in numbers is deep-rooted, so much so that rejection generates activity in the same part of the brain as physical pain. Thus, a contrarian value strategy is hardly an attractive biological proposition for most investors.
The world’s most successful investors have typically earned their reputation through a value strategy, though most novice and professional investors engage in dangerous return-chasing behaviour. Warren Buffett once quipped that, “Success in investing doesn’t correlate with IQ once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” Readers should take note.