In his new book titled, Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, the highly regarded American financial columnist Jason Zweig combines investing advice with recent discoveries in neuroscience, offering a look at how our brains may be working against us in our quest for long-term inve
sting success.
Weighing three pounds but holding 100 billion neurons, the brain is a complicated creature, capable of making difficult, rational decisions. But the brain can also push us to make irrational choices, like buying stocks at the peak of a bubble and selling them at their cheapest. In this article, we'll review some of the key takeaways from Zweig's book, providing some tips along the way for improving your investment decision-making skills.
Do You Think It's a Good Investment, or Do You Feel It?
According to Zweig, we're often caught in a battle between the rapid-acting, automatic brain and the analytical, detail-oriented brain. For example, that fund with high historical returns may look great at first blush--but if you take the time to calculate the portion of that return that went to fees and fund expenses, the performance may not be so tempting at the end of the day. We're particularly prone to making emotional decisions in strong bull or bear markets, when fear and greed get the better of analysis.
We think Zweig is right on the mark when he offers ways to prevent this sort of behavior. He emphasizes patience and long-term thinking, as well as the importance of avoiding the temptation--often out of laziness--to use historical returns as a substitute for analyzing what the future may hold. He also reminds investors to keep the composition of their entire portfolios in mind when making the decision whether or not to pull the trigger. The importance of maintaining a good level of diversification should not be underestimated, and Zweig specifically cites Morningstar's Instant X-ray tool as a handy way to keep tabs on your personal diversification levels and how a new investment might tip the scales. Last but not least, Zweig highlights the importance of evaluating and understanding the business behind the stock and not immediately getting swept up in forming a judgment solely based on price movement. This reminds us of another book we've recommended in the past, The Dhandho Investor, and author Mohnish Pabrai's focus on stock investing as buying a small piece of an active business.
Zweig is careful to point out that we shouldn't simply ignore our feelings; the goal is to find a balance between rational thought and intuition. After all, if you have reservations about a management team's qualifications, it might be smart to listen to your gut and pass on an investment. On the other hand, if you're able to quell those concerns with rational arguments, you'll be able to stand by the investment with that much more conviction.
Making the Most of Uncertainty with Less Risk
Anyone who has bought a lottery ticket understands the appeal of winning big, even if the odds are impossibly slim. In fact, our brains actually experience more pleasure at winning in a low-odds game than in a sure bet, partly because we are wired to place greater importance on anticipation than the actual outcome itself.
If investors just can't help but get swept up in the excitement of high-risk stocks or funds, we think Zweig makes a good suggestion: Create a "mad money" account (no more than 10% of your total portfolio), where you can take these kinds of risks without feeling guilty. We also think this attraction to risk makes for another interesting parallel to Pabrai's own philosophy and his emphasis on low-risk, high-uncertainty stocks. After all, if our brains foolishly derive more pleasure from high-risk, high-uncertainty investments, it stands to reason that Pabrai's picks might be neglected, and therefore undervalued, by the market. Similarly, long-term value investors may not see nearly as much day-to-day excitement as day traders, but we agree with Zweig that a long-term investing philosophy is a valuable weapon in creating a strong investment track record.
You Don't Need an Opinion on Everything
We're addicted to predicting; by nature, we simply hate to believe that anything is governed by randomness. As Zweig discusses, this addiction is chemical; dopamine in the brain can actually push us to see patterns where none exist, extrapolating from a handful of data points--or data that is more recent and therefore more memorable--to create larger, unfounded theories that can get you in heaps of trouble.
How can we get past this addiction? There are some simple ways to make sure you're behaving rationally. For example, make sure your fund expenses are on the low side; a total expense ratio of 1.60% is roughly average for UK equity funds, but many outstanding funds charge less than average. You can check the Fees & Expenses tab of each Morningstar fund report for information on a particular fund.
Maintaining control over the timing of your investment decisions is also critical; invest on a regular schedule, and not all at once or whenever you have the urge. Also, don't check the performance of your investments all the time (once a quarter is enough). It's easy to get caught up in short-term fluctuations, even if the long-term potential is still intact.
Overconfidence can also lead us to see patterns where none exist. As Zweig points out, surveys have shown that most of us tend to think we're above average. While this keeps our egos healthy, it can also lead us astray in the world of investing. We also often think we foresaw things that happened in the past, even if we didn't. This illusion, known as hindsight bias, can suppress fear and lead us to take extra risk. Zweig includes a particularly relevant quote in this section from Warren Buffett, who has said that what counts is "how realistically [investors] define what they don't know." In other words, admit what you don't know, and avoid investing in shares that you find particularly challenging to value or funds that you don't understand. We also approve of another tip that Zweig includes in his book: applying a discount to what you think a stock is really worth before diving into an investment. By using a margin of safety to account for the risks inherent in individual stocks, investors can provide an extra buffer against potential losses.
Moving Past a Bad Investment
One of the hardest things about a bad investment is acknowledging it and moving on. Zweig offers some great anecdotes here about fund manager behaviour; for example, Christopher Davis, manager of HSBC American Growth, has created a "mistake wall" that displays his investing mistakes and what he's learned from each one of them. Turning a mistake into a lesson can prevent you from repeating the error with another stock in the future.
By making rules to automate investing, you can also avoid regret from buying losers or not selling losers. Rebalancing investments periodically--say once or twice a year--and ensuring proper diversification are also key to staying on track with investing goals and avoiding regret. And with that, we wish our readers the best of luck in 2008.
