We’ve all heard the saying “trust your gut.” In fact, many of us take this approach more often than we realize when making decisions. Trusting your gut means looking inward, beyond the noisy chatter of thought, and toward that fuzzy space of perception–an arcane mix of instinct, intuition, and emotion–that somehow holds the mysterious power to direct you toward the “right” decision.

Instinctive gut reactions are often situational, taking into account what you are experiencing in the here and now. And in many instances, trusting this “inner voice” helps, particularly when all rational thinking has been exhausted, or when further reasoning only serves to over-complicate matters beyond productivity. But when it comes to investing, trusting your gut on a situational basis can lead you down a dangerous and potentially destructive path.

Given the extent to which we make gut decisions on a daily basis, why doesn’t it work when making investment decisions?  The answer, though simple, may come off as a bit bit odd: investing is often a counterintuitive act, particularly when you find yourself suppressing your own “natural” impulses to avoid the threat of risk or the pain of loss during moments of extreme market volatility or lengthy corrections.

 

Investing Creates Friction Between Long-Term Thinking and Short-Term Experience

Let’s start with the basic premise that investing in a portfolio of stocks is a “long-term” endeavor; long-term because businesses operate across relatively lengthy time horizons, from quarterly earnings to multi-year projections. The same can be said for economic forces. Sudden market jolts and shocks will almost always happen during the course of this unfolding, but such events are to be expected. The main point is that planning for the long-term requires long-term “thinking.”

And here’s the rub: long-term “thinking”–which covers a wide expanse of time in just a few moments of analytical thought–is very different from the real-time durational “experience” that investors face when implementing a long-term investment strategy. In short, long-term projections and short-term experience are qualitatively different factors that are not always compatible.

Investors should know that stock movements neither move in a straight line nor climb in steady incremental steps. In other words, fluctuations and volatility are the norm. To think about, plan for, and expect volatility is the easy part, as you are not engaging volatility itself, but rather, the “idea” of volatility. But in the realm of practical experience, volatility elicits a real sense of visceral uncertainty; plunging you into fear, doubt, and at times, panic; tempting you to make rash decisions regardless of your sound reasoning and long-term planning.

 

Investors Tend to Fixate on and Magnify Losses

According to a study involving a sample group of U.S. investors (conducted in 1979 by economists Daniel Kahneman and Amos Tversky), its findings estimated that the pain of loss felt by investors was approximately two and a half times greater than positive responses to equivalent gains. Behavioral finance has a name for this bias: myopic loss aversion. “Myopic” meaning nearsighted or shortsighted: a tendency to fixate on short-term drawbacks at the expense of long-term “vision.”

The emotional impact of this bias can be significant. A loss of 10%, multiplying that figure by 2.5, would feel like a loss of 25%. If we take that even further, a loss of 25% would feel like a 62.5% loss! If the study’s participants comprise a micro-sample of investors across the globe, then we’d come to the general conclusion that investors’ emotional response to profit and loss is significantly rigged in favor of the negative and skewed toward the recent past.

So how does this play out in a real-life investing scenario? What happens when a well-thought-out investment plan goes up against the experience of short-term volatility or loss; one that elicits an instinctive “fight or flight” response? The consequences are generally unfavorable, yet common.

 

Turning Buy Low/Sell High Upside Down

The basic premise for any investment is quite simple…in theory, that is: buy low and sell high. No matter how well you analyzed a market, you can never be certain that your buy point was low enough, nor can you be certain that your stock will rise. You can’t predict the future. However, you can make a reasonable projection based on what you do know, or by perceiving what everyone else sees but “differently.” Just bear in mind that projection is not the same as prediction.

Buying low and selling high may seem like a simple concept; start here, end there. It’s never that simple: the duration between buying and selling is rife with unknowns, most of which materialize as fluctuations; often unfavorable, and at times, quite volatile. To make matters worse, your perception of these factors are often shaped, or bent out of shape, by your own instinctive aversion to risk. The bottom line is that if you allow yourself to get drawn into the chain of momentary uncertainties that sometimes dominate this in-between space, you run the risk of inverting the very premise upon which all investing efforts are grounded: you may end up buying high and selling low.

How so? Take a look at the example below. This chart illustrates a composite of U.S. and world stocks for the entire year of 1998, a year in which stocks delivered a strong performance of 24.3%.

 

cognitive-part-2-300x187 Cognitive Biases: A Hidden Investment Risk – Part 2

 

1998 ended up being a great year for world stocks. But its volatility made the experience a remarkably trying endeavor. The previous year’s Asian financial crisis bred fears of financial contagion on a global scale. This crisis eventually led to Russia’s debt default. In the U.S., hedge fund Long Term Capital Management (LTCM), holding oversized bets on Russian bonds, collapsed. Investors feared that LCTM’s failure would crash the entire U.S. financial system. Hence, the sharp -20.3% correction.

Fueled by extreme sentiment, namely fear and panic, market downturns move much faster and sharper than upward advances. Steep plunges tend to trigger the “fight or flight” response in most investors, preventing them from approaching the larger fundamental outlook from a cooler, more rational perspective. This is generally true of most market corrections, and we can see how this dynamic took place in 1998.

A 20.3% drop is huge. But for most investors who had the tendency to magnify the emotional impact of losses, it probably felt closer to a 50.75% drop! What would you have done in a case like this–stay the course as planned, or follow your gut and exit? The market quickly found its footing and resumed its advance, ending the year with a 24.3% gain.

In hindsight, it’s easy for us to affirm that the right move was to stay the course. That’s because we have the privilege of seeing the outcome. But in every investment scenario, you can only reach the far horizon of your destination by navigating through the omnipresent fog of uncertainty.

The crucial question is, should you navigate by plan, or whim; by reason, or sentiment; by strategy, or impulse?

 


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