Stordahl Capital Management’s Evidence-Based Investment Insights: Insight #11: The Human Factor in Evidence-Based Investing
Welcome to the next installment in our series of SCM’s Evidence-Based Investment Insights: The Human Factor in Evidence-Based Investing.
In our last piece, What Has Evidence-Based Investing Done for Me Lately? we wrapped up our conversation about evidence-based investing in stock, bond, and potential alternative markets. We also described how to extract the diamonds of promising new evidence-based insights from the overwhelming piles of noisy news.
We turn to the final, and arguably the most significant factor in your evidence-based investment strategy: the human factor. In short, your own impulsive reactions to market events can easily outweigh any other market challenges you face—occasionally for better, but usually for worse.
Exploring the Human Factor
Despite everything we know about efficient capital markets and all the evidence available to guide our rational decisions … we’re still human. We’ve got things going on in our heads that have nothing to do with higher reasoning. Instead, a brew of chemically generated instincts and emotions often spur us to leap long before we have time to look.
Rapid reflexes can serve us well. Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running, no questions asked; their laughter elicits an outpouring of unconditional love (and oxytocin).
In finance, however, where the coolest heads prevail, many of our base instincts cause more harm than good. If you don’t know it’s happening or don’t manage it when it occurs, your brain’s chemistry can trick you into believing you’re making entirely rational decisions when you are in fact acting on impulse.
Put another way by neurologist and financial advisor William J. Bernstein, MD, PhD:
“Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.”
Behavioral Finance, Human Finance
To study the relationships between our psychological and financial health, there is another field of evidence-based inquiry known as behavioral finance.
What happens when we stir up that proverbial Petrie dish of financial pathogens? Daniel Crosby’s “The Behavioral Investor” provides a guided tour of various academic findings that describe what’s happening inside our heads to generate our financial behaviors:
“Our brains have remained relatively stagnant over the last 150,000 years, but the complexity of the world in which they operate has exponentiated. … It would be a gross understatement to say that our mental hardware has not caught up to the times.”
To offer a couple examples:
When markets tumble: Your brain’s anterior insula lights up in its mammalian depths, just as it does when you experience physical pain. Fear drives the needle to “Sell!”
When markets unexpectedly soar: Your nucleus accumbens activates your brain’s arousal center, convincing you that you had best act soon to seize the day. “Buy!”
An Advisor’s Greatest Role: Managing the Human Factor
Beyond the market-timing instincts that lead you astray, your brain cooks up plenty of other sneaky biases to alter your investment activities. To name a few (which we’ll cover next), there’s herd mentality, recency, confirmation bias, overconfidence, loss aversion, and sunken costs.
Your Take-Home
Managing the human factor in investing is another way an evidence-based financial practitioner can add value. By spotting where you may fall prey to a behavioral bias, we can hold up an evidence-based mirror, so you can see it too. Next, we’ll explore some of the more potent behavioral biases every investor faces.
We would be happy to speak with you individually about the latest evidence on factor investing and how to best apply it to your investment strategies. We offer a complimentary 15-minute call to answer your questions and to share how we can help.
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