Why Are Humans Hard-Wired to be Bad Investors?

Why Are Humans Hard-Wired to be Bad Investors?

Today on ThinkSmart with TMFG Financial Planners Rob McClelland and Mike Connon discuss some of the science behind what leads humans to be bad investors. Investing is easy, isn’t it? Well, maybe not with all the parts that make up the human psyche, you might be surprised that we ever have a successful outcome. Today we discuss; Anchoring, Sunk Cost Fallacy, Back-fire effect, and Belief Bias amongst a host of other tendencies that investors tend to lean on. Join us to learn more.

 

Transcription

Rob (00:00):

Hello, this is Rob and Mike from The McClelland Financial Group of Assante Capital Management and this is Think Smart with TMFG. Today on Think Smart with TMFG, Mike and I are going to be discussing how humans are actually wired to be bad investors. Mike, it’s been interesting, we’ve started 2022, we’re coming off one of the best years in, certainly in the 30 years that you and I have been looking after clients’ investments, and yet I’m finding client behaviour is a little strange, and people aren’t happy. They’re very worried about everything that lies ahead, whether it’s rising interest rates or rising inflation or the government pulling back support. Whatever it is, they’re very concerned. They can’t even enjoy the fact that they’ve had a great year.

Mike (00:59):

You’d think this would be a new thing, wouldn’t you? But I remember when we started, remember, I think it was the New York Times that had article of monkeys throwing darts at the stock page that were outperforming most people and most professionals. So I think this has been a long-term problem.

Rob (01:16):

So I thought it might be interesting to explore some of the, let’s call it the science behind it. Why are humans not great as investors? What are some of the reasons that have been documented and recorded as this is why we struggle with investing? Because investing should be relatively straightforward.

Mike (01:36):

Yeah. There’s a bunch of different things that we tend to do. And to be honest, men are worse than women from all the studies I’ve seen too in all these areas.

Rob (01:44):

So let’s start with one, it’s called anchoring. The first thing you judge influences your judgment of things that follow. And I’ll give you just a simple example of anchoring, not even an investment way. But if you go into a car dealership and the guy says to you, as you’re looking at a certain vehicle, he says, “The brakes have had some issues with this one.” You cannot get that thought out of your mind. It’s there permanently. You will quite likely not buy that car because you’re worried about the brakes. Or if you do buy that car, the very first time you hear a squeak on the brakes, you’re going to go, “He was right.”

Rob (02:23):

So what are some examples of anchoring in the investment industry?

Mike (02:29):

I’ve heard many clients say, “I don’t want to buy mutual funds. They’re just expensive and they’re bad.” They don’t even know what a mutual fund really… Which mutual funds, I always go on to say, say, “Well, what do you mean? Are you talking about bond funds or equity funds or derivative funds? What are we talking about?” There’s something that’s bad out there, but a blanket statement across the idea that mutual funds, mutual funds is just a group of different stocks put together. There is no way they could be bad or good on a blanket term.

Rob (02:58):

And you’re right. Are they bad compared to each other? Are they bad versus exchange-traded funds, which are a relatively new investment, or are they bad versus stocks or bonds? And so what often is they’re expensive. Well, yes, there’s some expensive mutual funds. I totally agree. There’s some very inexpensive mutual funds as well. But once you’re anchored that mutual funds are bad, you probably have a hard time buying them.

Mike (03:24):

It’s funny, as soon as I hear that from someone I realize their understanding of investments is very limited.

Rob (03:31):

Definitely. Sunk cost fallacy. So the example here is you’ve put money into an investment. You’ve bought a stock, let’s say, or even a mutual fund, and you’ve put in $20,000. The mutual fund doesn’t really know that you bought $20,000 of it. The stock certainly doesn’t know that you put $20,000 in it. You’re the only one who knows that. Now, if that stock or mutual fund is now worth $12,000, it’s gone down 40%. A lot of investors will continue to hold it until it comes back. Is that the right move?

Mike (04:10):

I went to a presentation many years ago and they were describing this same type of investment. And they discussed this is why most wars break out. And the idea, if you go back to the Vietnam War in the US, they, they sent in a thousand troops to win this battle, and 500 or 600 people died. And they said, “Well, we don’t want those people to die in vain, so we better make sure we don’t lose this war. So let’s send in another 5,000.” Then, of course, they lost more. And they said, “Well, now we’ve lost 3000 people. They can’t die in vain. So let’s put in 100,000 and make sure they’re not dying in vain.” And by the end of it, it’s not really for the original purpose of the war. It’s just to prove that you didn’t lose these lives for no reason. And many wars have happened for this reason. People don’t want accept that they have a loss, so they’d rather go and fight until they get at least that win, even though it no longer serve as a purpose.

Rob (05:08):

So the next one is confirmation bias. And I think a great example today is this, that it’s okay to be unvaccinated, that this whole COVID thing is a scam. And the difference today is it’s really easy to confirm that belief because all the media that is sent to you through social media, through all these different websites that you subscribe to confirms your beliefs. How does that imply to investing?

Mike (05:40):

Well, you’re looking for a certain amount of information. And if you’re a pessimist, you’re going to be looking for things that are wrong in the marketplace. And if you’re an optimist, you’re going to be looking for things that are right. So depend on your initial view and what you put your Google search on. Are we headed toward the biggest market crash ever? You’re going to get a lot of articles that are going to say, “Yes you are.” And if you say, “Are we about to head into the best bull market in the this century?”, you’re going to find a bunch of articles that will go and support that theory. So whatever you’re going to search, you’re going to find a lot of proof of your idea.

Rob (06:14):

I have a funny example actually. I’ve noticed over the last month, almost every article I open is trying to sell me a German hearing aid. Now, they’re all different hearing aids. A lot of them are the same, but it’s literally every article I open. And I began to wonder, I’ve never searched for hearing aid. To my knowledge, I don’t really have a hearing problem. Is it because I’ve turned the volume up too high on my computer and that they’ve triggered that, and that says that I probably need a hearing aid?

Mike (06:48):

That would be scary good, wouldn’t it?

Rob (06:49):

That would be really good, but we may be there. Who knows?

Rob (06:52):

Something called backfire effect. When your core beliefs are challenged, it causes you to believe in things even more strongly.

Mike (07:02):

Well, this goes into basically back into the ego. If you go this back into Freud’s terms, everyone has an ego. And the ego is there is to protect you, and the ego does not want to be wrong. And the more it gets pushed, the more strong the ego will become. And that’s basically what you’re fighting in there.

Rob (07:19):

A next one is called declinism. This one’s interesting. You remember the past is better than it was, and expect the future to be worse than it will likely be. So despite today, when we are living in the most peaceful and prosperous time in history, there are more middle-class today than there has ever been. Most people believe that things are getting worse. And I guess this is a bit of the example of coming off a great year, and everyone’s not worried about having a great year and having more money in their account, they’re worried about what happens next.

Mike (07:59):

Remember years ago, you went to see Colin Powell, and he said at that time, this is the most peaceful the world has ever been. And it seemed shocking because all the news had everything was going on, but his comment was you just didn’t know what was going on before. So no matter what happens, we have so much exposure to news. You don’t realize how good the world is actually in a position right now.

Rob (08:21):

Belief bias. If a conclusion supports your existing beliefs, you rationalize anything that supports it. So what do you think of that one?

Mike (08:31):

Again, war human nature. Everyone wants to be right.

Rob (08:34):

So we automatically start defending our ideas without ever really questioning where we got those ideas. We all, we grew up in different families. We all have different core beliefs. Some people grew up in a family where they believe stocks are bad because maybe their parents lost money, or maybe their grandparents lost money in a stock market crash and never recovered. So these things are often very difficult to overcome as an investor. You mentioned, you touched on negativity bias. What’s that? Why is that difficult to be a successful investor?

Mike (09:13):

Well, the pain of negative experiences greatly outweighs the pleasure of positive experiences. We had someone in a company named Michael [inaudible 00:09:21] once, when he gave that description where he described, he said to grab your hand and massage it gently, and that’s a strong marketplace. And he said for a weak marketplace, take your pencil and ram through the center of your hand. And he said there is a disproportionate amount of pain attached to a negative marketplace and the pleasure that’s attached to a positive marketplace, and it sticks in your memory.

Rob (09:42):

So a 20% return is probably equivalent in pleasure to maybe a 10% loss, right?

Mike (09:50):

Yeah.

Rob (09:50):

Or not in terms of pleasure, but those two would be considered equal. When logic would say a 10% loss, a 10% gain, half the time I’m going to be zero.

Mike (10:01):

Yeah. People don’t actually… The brain is not necessarily always doing math. Math and emotions are two separate pieces of the brain. And when you think with emotions, it’s not doing the equations.

Rob (10:11):

A good way to get through something like that is to always create pros and cons. What are some of the advantages and disadvantages of what I’m facing, whatever that decision may be?

Rob (10:21):

The flip side of that is optimism bias. You overestimate the likelihood of positive outcomes. And I often see this with couples. You’ll have one individual who’s just far too optimistic. I don’t know if they’re not there because their spouse is pessimistic, but I think that’s often the case. Any good examples of that?

Mike (10:43):

I’ve seen a lot of entrepreneurs have to be optimistic, right? And many of them are proportionally optimistic, which is good. But every now and again, you find the dreamers, which are a bit too far-fetched, and that’s when you find they get into financial problems. It’s more of a dream world than a reality of how things are going to actually work out. And the difference is the people who are great entrepreneurs, take everything, put it to paper and put a plan around it to show how it’s going to work. The people that are overly optimistic sometimes just have the dream, and they don’t ever want to put it to paper because they don’t want to deal with the reality of things.

Rob (11:18):

So here we are in 2022. We’ve come off a great year. I’m not saying be optimistic about 2022. No one knows how the year will finish, but I am optimistic about the next five years and the next 10 years. That brings us to the end of another week. Thank you for joining us. This is Rob and Mike with Think Smart from The McClelland Financial Group of Assante Capital Management, reminding you to live the life that makes you happy.

Assante Capital Management (12:08):

You’ve been listening to The McClelland Financial Group of Assante Capital Management Limited. Assante Capital Management Limited is a member of the Canadian investor protection fund and the investment industry regulatory organization of Canada. Insurance products and services are provided through Assante Estate and Insurance Services Incorporated. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources. However, no warranty can be made as to its accuracy or completeness. Before acting on any of the previous information, please make sure to see a professional advisor for individual financial advice based on your personal circumstances. The opinions expressed are those of the authors and not necessarily those of Assante Capital Management Limited.

 

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