Getting out of our own way – the psychology of investing

Posted by Gavin Chau

“The investor’s chief problem—and even his worst enemy—is likely to be himself.”

Benjamin Graham

The current market with spiking bond yields, the mysterious bombing of the Nordstream pipelines, tanking stock markets, high inflation, geopolitical tensions and war, rising interest rates, and talk of global recession seems endlessly bearish. But it also makes me think that we’ve probably seen the bottom already. You’ve got to wonder how likely it is that the whole internet is simultaneously correct in their calls for lower lows in asset markets. Markets are overwhelmingly controlled by investor emotions. At the bottom, the majority always expect prices to fall lower, and at the top, prices to go higher. Why this is the case is due to our limbic system.

The limbic system is the part of the brain wired for emotions and fight or flight responses. It’s an ancient part of our brain that has evolved over 150 million odd years. In contrast, the prefrontal cortex, which controls the higher functions of rational thought and logic, is far more recent, having only developed over the last 500,000 years or so. Our brains have evolved in such a way that they have many more connections running from our limbic system to the cortex than the other way around.

The noise from the limbic system can drown out the quieter signals running in the other direction. Markets being visual representations of greed and fear, are controlled almost entirely by the limbic system. It’s why the graphs of market cycles are shaped the way they are and why investing well over the long term is only achieved by a relative minority. The extent to which you succeed in finance and investing depends on how successful you are in suppressing your limbic system.

Morgan Housel touches on this in his excellent book The Psychology of Money: Timeless Lessons on Wealth, Greed and Happiness. It’s why people with no formal training in finance can have excellent investing records. Investing isn’t just about knowledge of finance or reading the interest rate cycle accurately. It’s equally about mastering our emotions and behaviours and how we handle things like greed and risk, our own ego, and our temperament.

On the other end of the spectrum, there are people with Ivy League educations, high IQ’s, working at the best investment banks with the best financial education using the most sophisticated models who go bankrupt.

There are probably no other industries where someone with no education can massively outperform someone with the best background and training. For example, it is difficult to imagine that happening in medicine where someone with no medical experience can perform brain surgery better than a Harvard-trained surgeon. Yet it happens regularly in investing.

The truth is investing successfully is mostly about doing simple things over and over again. Such as saving some money each week and dollar cost averaging into the share market or adding properties to your portfolio whenever you can afford to and sitting on it for as long as you can. This is probably 80% of investing, and it’s so simple, so boring, and so basic that nobody goes to Harvard business school to learn that. We often just focus on the other 20% because it’s more complicated, more exciting, and more mentally stimulating.

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Posted by Gavin Chau, on 1st Nov 2022