Human Nature And Investments Don't Mix

By David McEwen

Monday 2nd July 2001

Investors often appear to take leave of their senses during a volatile market, buying assets that are later found to be ludicrously expensive or selling them ridiculously cheap.

However, new research into the human mind indicates that people are not inherently foolish. Rather, they are misled by deeply ingrained instincts and habits into taking actions that are contrary to their best interests.

This applies particularly to investments, where cool heads are generally needed for success. The recent bubble in technology shares is an example and many investors will be wondering what possessed them to pay high prices for companies with virtually no assets and no income.

The trouble is, millions of years of human evolution have relied on snap judgements and gut feel. Fear and greed, fight and flight are all life-saving instincts in the right situation. Unfortunately, they rarely do much good when applied to the unemotive subject of managing money.

Here are how some ancient instincts hamper us when investments are concerned:

Ignoring probabilities

For some obscure reason that probably once helped our distant ancestors survive, the human brain is wired to rely on the recent past as a guide to the future. That may not be too harmful in predicting where to go hunting, but financial assets are a different story. People tend to believe a rising or falling market will continue to do so even though logic would dictate that sooner or later it will go the other way.

Tribal instincts

When a member of our ancestor's tribe spotted dinner on the hoof or a man-eating predator, it was in everyone else's interest to pay attention as well.

These days, people still tend to focus on what has attracted other people's attention. In a market, these are often assets that have risen strongly, leading to people buying at prices that otherwise might be considered absurd.

Humans also have a deep-seated desire to conform in order to preserve their status within a group. On the market, this can lead to the famous 'herd mentality' where investors buy because, well, everyone else is buying.
Wishing for success

Our ancestors didn't want to waste valuable spears or arrows so developed a preference for taking actions only when they believed the chance of success to be high. Unfortunately, many people have a higher opinion of their abilities than logic would dictate, and this seems to apply particularly to investments. People can also suffer a 'wishful thinking bias' where they overestimate the chance of success of an asset that they feel some association with.

Trusting the experts

It didn't take our ancestors long to start specialising. Every tribe had its chief, medicine man, hunt leader and so on. This meant that, instead of trying to absorb vast amounts of information, humans could rely on the specialist's experience. Investors today still instinctively make the assumption that an 'expert' has already done all the necessary research without checking to see if this is actually the case. If they are wrong, the outcome can be very painful.

The best way to override these instincts is to develop a firm set of criteria for deciding what investments to buy and sell, and when to buy and sell them. Success will comes from adhering to these criteria when every fibre of your being is telling you otherwise.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz or by mail care of this newspaper.

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