Markets & Mind Games
Would you willingly allow a certifiable lunatic to come by at least five times a week to tell you that you should feel exactly the way he feels?
Would you ever agree to be euphoric just because he is or, miserable just because he thinks you should be?
Of-course not!
You’d insist on your right to take control of your own emotional life, based on your experiences and your beliefs. But, when it comes to their financial lives, millions of people let Mr. Market tell them how to feel and what to do despite, the obvious fact that, from time to time, he can get nuttier than a fruitcake.
Why, then, do investors find Mr. Market so seductive?
Let us find the psychological connection between -
The Market and Your Mind
It turns out that our brains are hardwired to get us into investing trouble. Humans are pattern-seeking animals. Psychologists have shown that if you present people with a random sequence-and tell them that it’s unpredictable-they will nevertheless insist on trying to guess what’s coming next.
Take this experiment explaining pattern confirmation conducted by the psychologist P. C. Wason illustrated by N.N.Taleb in his book Black Swan
The Task :
Wason presented subjects with the three-number sequence 2, 4, 6, and asked them to try to guess the rule generating it. Their method of guessing was to produce other three-number sequences, to which the experimenter would respond “yes” or “no” depending on whether the new sequences were consistent with the rule. Once confident with their answers, the subjects would formulate the rule.
After tinkering for hours and giving numerous complex combinations the subjects could not give the right answer.
The Answer :
The correct rule was “numbers in ascending order,” nothing more. Very few subjects discovered it because in order to do so they had to offer a series in descending order (that the experimenter would say “no” to).
Wason noticed that the subjects had a rule in mind, but gave him examples aimed at confirming it instead of trying to supply series that were inconsistent with their hypothesis. Subjects tenaciously kept trying to confirm the rules that they had made up.
Once your mind is inhabited with a certain view of the world , you will tend to only consider instances proving you to be right. Paradoxically, the more information you have, the more justified you will feel in your views
Ground-breaking research in neuroscience shows that our brains are designed to perceive trends even where they might not exist. After an event occurs just two or three times in a row, regions of the human brain called the anterior cingulate and nucleus accumbens automatically anticipate that it will happen again. If it does repeat, a natural chemical called dopamine is released, flooding your brain with a soft euphoria.
Thus, if a stock goes up a few times in a row, you reflexively expect it to keep going and your brain chemistry changes as the stock rises, giving you a ‘natural high’. You effectively become addicted to your own predictions.
But when stocks drop, that financial loss fires up your amygdala - the part of the brain that processes fear and anxiety and generates the famous ‘fight or flight’ response that is common to all cornered animals.
Just as you can’t keep your heart rate from rising if a fire alarm goes off, just as you can’t avoid flinching if a rattlesnake slithers onto your hiking path, you can’t help feeling fearful when stock prices are plunging.
In fact, the brilliant psychologists Daniel Kahneman and Amos Tversky have shown that the pain of financial loss is more than twice as intense as the pleasure of an equivalent gain. Making $1,000 on a stock feels great-but a $1,000 loss wields an emotional wallop more than twice as powerful.
Losing money is so painful that many people, terrified at the prospect of any further loss, sell out near the bottom or refuse to buy more.
That helps explain why we fixate on the raw magnitude of a market decline and forget to put the loss in proportion. So, if a TV reporter hollers, “The market is plunging-the Dow is down 100 points!” most people instinctively shudder. But, at the Dow’s level of 8,000, that’s a drop of just 1.2%.
Now think how ridiculous it would sound if, on a day when it’s 81 degrees outside, the TV weatherman shrieked, “The temperature is plunging-it’s dropped from 81 degrees to 80 degrees” That, too, is a 1.2% drop. When you forget to view changing market prices in percentage terms, it’s all too easy to panic over minor vibrations.
What then must one do to tackle these psychological biases?
Recognize that investing intelligently is about controlling the controllable.
Things you cannot control -
- Market volatility: Stock prices can fluctuate rapidly due to various economic and geopolitical factors, and no one can predict or control these fluctuations.
- Interest rates: Interest rates set by central banks can have a significant impact on the stock market. However, individuals cannot control these rates.
- Global events: Wars, natural disasters, pandemics, and other global events can affect the stock market in unpredictable ways, and individuals have no control over these events.
- Company-specific news: A company’s stock price can be affected by news about its earnings, management changes, and other internal factors. Again, individuals cannot control these factors.
- Investor sentiment: The mood of the market can be influenced by investor sentiment, which is largely driven by emotions rather than rational analysis. This sentiment can cause stock prices to rise or fall, and individuals cannot control it.
- Market regulations: Governments and regulatory bodies can impose rules and regulations that can affect the stock market. These regulations are beyond an individual’s control.
In summary, while there are many factors that can impact the stock market, there are several things that individuals cannot control. It is important to understand these factors and their potential impact on investments.
The points below are backed by FinSharpe’s data analytics. Click on the sub-headings to see the research articles.
Things you can control -
- Investment Strategy: Individuals can choose an investment strategy that aligns with their goals and risk tolerance. They can select from various asset classes, such as stocks, bonds, and real estate, and decide on their asset allocation.
- Investment Timeframe: Individuals can decide on their investment timeframe, whether it is short-term or long-term. This can help them choose investments that are appropriate for their goals.
- Diversification: Individuals can diversify their investments by spreading their money across various asset classes, industries, and geographies. This can help reduce the risk of loss in the portfolio.
- Investment Fees & Brokerage: Individuals can control the fees they pay for investing. They can research and choose low-cost investment options to maximize their returns. Reduce excessive trading costs by trading infrequently and buy mutual funds or strategies with a low expense ratio.
- Monitoring and Rebalancing: Individuals can monitor their investments regularly and rebalance their portfolio if necessary. This can help ensure that their investments remain aligned with their goals and risk tolerance.
- Emotional Reactions: Individuals can control their emotional reactions to market fluctuations by avoiding impulsive decisions based on fear or greed. One way to deal with this is to structure investments automatically spread out over different dates in a month.
In summary, while there are many factors that individuals cannot control when it comes to investing, there are several things that they can control. By focusing on these controllable factors, individuals can make informed investment decisions and maximize their returns over time.
Apply the Real Estate Investing Mindset to Equity Investing
If, after checking the value of your investment portfolio at 1:24pm , you feel compelled to check it all over again at 1:37pm , ask yourself these questions:
Did I call a real-estate agent to check the market price of my house today at 1:24 P.M.?
Did I call back at 1:37 P.M.?
If I had, would the price have changed?
If it did, would I have rushed to sell my house?
By not checking, or even knowing, the market price of my house from minute to minute, do I prevent its value from rising over time ?
The only possible answer to these questions is Of-course not! And you should view your long term portfolio the same way. Over a long term investment horizon, Mr. Market’s daily dipsy-doodles simply do not matter.
In any case, for anyone who will be investing for years to come, falling stock prices are good news, not bad, since they enable you to buy more for less money.
The longer and further stocks fall, and the more steadily you keep buying as they drop, the more money you will make in the end-if you remain steadfast until the end.
Instead of fearing a bear market, you should embrace it.
The Intelligent Investor should be perfectly comfortable owning a stock or mutual fund even if the stock market stopped supplying daily prices for the next 10 years.
Paradoxically, “you will be much more in control, explains neuroscientist Antonio Damasio, “if you realize how much you are not in control”.
By acknowledging your biological tendency to buy high and sell low, you can admit the need to dollar-cost average, rebalance, and follow a disciplined investment process.
By putting much of your portfolio on permanent autopilot, you can fight the prediction addiction, focus on your long-term financial goals, and tune out Mr. Market’s mood swings.
The source of information for this article is from the following books which I highly recommend :
- The Intelligent Investor by Benjamin Graham
- The Black Swan by Nassim Nicholas Taleb
- Thinking Fast and Slow by Daniel Kahneman
- The Molecule of More by Daniel Z. Lieberman and Michael E. Long
I am a SEBI Registered Investment Advisor. If you would like to structure your investment portfolio or invest in long term equity strategies, connect with me on rohan@finsharpe.com
