“Be fearful when others are greedy and greedy only when others are fearful” is one of the most famous investment quotes of the last 15 years. Of course, this was written by Warren Buffett as a way of demonstrating his contrarian behavioural philosophy, yet most investors can attest to the difficulty of implementing his wisdom.
In the ups and downs of life, people are often required to face complex financial decisions – whether they should save, spend or invest at a simplistic level - and the final decision is heavily influenced by risk, probability, prior experience and social interactions. This often leads to gut reactions and the ‘F’ word – feeling; common emotional responses among individuals trying to understand the best way forward. The question we pose is whether it is right to trust your gut? What can we do to make better decisions? For this, we can draw on some lessons from high performance training and neuroscience.
Learning the Right Things
We are usually taught that the learning cycle follows a simple trajectory, whereby time and performance are positively correlated.
The typical example is a tennis player. Roger Federer can hit a backhand winner without really thinking about what he is doing, and this unconscious competence is said to be the elite mode of thinking, forming the key to peak performance. However, in the investing world, unconscious competence opens us up to a long list of behavioural deficiencies that can become counterproductive if left uncontrolled. To understand this further, we explore four sections of the brain, the first two of which are generally good for investing and the latter two mischievous.
The Rational and Reflective: Prefrontal Cortex
The prefrontal cortex is the most reliable part of our brain and the area we want to reinforce most of our analytical output – it is known as the brain’s boardroom. It is what helps people think, communicate, restrain actions, learn from mistakes, control memory and ultimately make rational decisions. It is also known as the ‘reflective brain’. It has many strengths and has a distinct ability to identify fair offers and to reject unfair offers.
However, it is not without weaknesses. The prefrontal cortex has a limited capacity, meaning it can only process a certain amount of information at any one time – recall when you forget someone’s name just after meeting them. It is also known to prefer instant rewards over future rewards, and is known to react to fear and greed, albeit in a more controlled manner than in our automated areas of the brain.
The Long-Term Memory: The Hippocampus
We all have a relative or friend that has an exceptional long-term memory. But while their trivia skills may be the show, it can also help them collect the dough. Successful investing and experience are considered to be highly correlated, and a strong long-term memory helps provide perspective during the market cycles and inevitable setbacks. It is also known to change in size depending on how often it is exercised, so teaching our mind to focus on long-term analysis can potentially help investment performance.
Irrational Fears: The Amygdala
This section of the brain is responsible for irrational fears such as arachnophobia and can easily influence illogical decision making. It is the area of the brain that makes contrarian investing so difficult in practice, even when we know it works in theory. In an investors case, this is usually triggered among a crisis, creating an overwhelming sense of fear that leads an investor to stray from their preferred investment style.
Greed is Good: The Nuclei Accumbens
The brain’s reward centre is a powerful phenomenon, but tends to have an irrational impact on investment decision-making. It is the reason the rich want to get richer, even if they have enough money to comfortably meet their long-term needs. The reason this reward centre is so powerful and hard to control is that it is responsible for feelings of happiness.
Creating a Roadmap for Behavioural Performance
The question is whether a roadmap is possible on the best way to turn on our brains in the right areas and dull out the prohibitive ones.
This focus on the conscious makes a lot of sense, and is backed by a healthy and growing amount of scientific grounding. In this regard, there are a few techniques that can be used effectively, and while this list is not exhaustive and somewhat theoretical, it should help to identify potential areas to improve our behavioural biases. As you read this list, we encourage you to think about your behaviour during the financial crisis and whether you remained disciplined in your analytical thinking throughout.
Lesson 1 – Lifelong Learning
London cab drivers are said to have a larger hippocampus – long-term memory – than an ordinary person, and the size of the hippocampus is highly correlated to the amount of experience they have. Therefore, if one wants to build on their investment strength, learn as much as you can about financial market history and the long-term drivers of returns.
Lesson 2 – Make Decisions When Calm
There are many problems with stress and its impact on performance. Firstly, it is important to minimise unnecessary exposure to fear-related anxieties via the amygdala. Even in the prefrontal cortex, stress can reduce working memory performance. Sleep is incredibly important in this regard.
Lesson 3 – Enjoy the Process
Positive thinking is known to increase activity in the prefrontal cortex. Therefore, typical exercises such as laughing, expressing gratitude and focusing on positive stories can supposedly help create the ideal mindset before making investment decisions.
Lesson 4 – Turn on the Mind
There are multiple ways to increase dopamine in the prefrontal cortex, including caffeine. This is known to significantly reduce impulsivity and may help performance. However, excessive amounts of dopamine are said to destroy blood flow to the prefrontal cortex and can also create in imbalance in our reward systems.
Lesson 5 – Put Yourself in the Future
By taking your perspective to a different place, you are forcing your mind to be reflective. A great question to tackle is something akin to “in 5 years’ time, what would cause me to sell this investment?”. Once again, this activates the prefrontal cortex.
Lesson 6 – Avoid the Drama
Gossip and confrontation fire up the amygdala and sends the prefrontal cortex off course. If it is possible, any negative feedback loops should be held off until the investment proposal is structured.
Lesson 7 – Write your Synopsis on Paper
Writing words and reading aloud are both shown to be effective ways to activate the prefrontal cortex, which can promote rational decision making. A portfolio committee can help manifest this into a sound investment process.
