I recently finished reading “The Undoing Project” by Michael Lewis which follows the private and public lives of two psychologists: Daniel Kahneman and Amos Tversky. These two psychologists were the first to really examine the psychology of decision making. One of the takeaways from this book was the fact that our brains are in many ways still hardwired like they were tens of thousands of years ago when “early man” was just learning how to survive on earth. Although our thought process has served us well over time, our “instincts” can be counterproductive when it comes to investing.
Kahnamen and Tversky discovered that most people will pick a sure loss of $500, instead of taking a “gamble” that results in either no loss or a loss of $1000. Why? Humans have an instinctual aversion to risk. Kahnamen and Tversky trace this risk aversion back to our evolutionary past : “a heightened sensitivity to pain was helpful to (evolutionary) survival” – according to the psychologists.
What are the investment implications of this discovery? We know that humans are risk averse and that losing money in the stock market is a “risk”. When we start to experience investment losses, our first instinct is to stop further pain/losses from occurring. Selling stocks and moving to cash takes away the “pain” we feel from losing money. Also, because we are risk averse by nature, investors often look to the calendar to figure out if there are any risks that can be avoided. The plan is to sell ahead of the event, then buy back at lower prices when the markets head lower.
The problem with avoiding risk is that markets reward investors for taking risk – there is no reward without risk. 2016 was a great example of this – Brexit and the US election were huge “risk events” that everyone knew were coming. Our human aversion to risk told us to stay out of the market during these risky votes. Although the markets did move lower during both of these events, the selling lasted only a day or two. Markets rallied significantly after both events and if you were sitting in cash for too long you missed significant returns. S&P 500 investors were rewarded for staying invested in 2016 with a 11.96% return*.
What you can do as an individual investor is to use your human instincts to your advantage. The next time stocks are really selling off, take a minute to think about how you feel. Are you scared? Do you want to sell your stocks and go to cash? Afraid the selling will continue forever? Now think about the investors all over the world that might be feeling the same way. I bet many are hitting the “sell” button on their accounts at the same time you are considering it. But if everyone is selling, its possible there are few sellers left and the buying will return in short order. A great way to check your instincts with reality is to use the CNN Fear and Greed Index – link below. If this indicator is flashing “extreme fear” we know that the very worst is already priced into the financial markets – the slightest improvement in economic data or sentiment can push the markets higher when everyone is panicking.
Cavemen run from risk – the modern day investor embraces risk.
*The above article is informational in nature only and is not a recommendation to buy or sell securities. All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information. All investments carry a degree of risk. Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.