Updated: May 17, 2022
Behaviour is everything. Our collective behaviour determines whether we as societies or as a race are creating or destroying. From time to time, the behaviour of certain individuals can have a particular influence on this collective behaviour.
"Perfection is elusive if not unachievable"
The behaviour of employees, whether top management or those lower down, determines how a company will perform. The behaviour of government officials guides incentives via taxes and policies. The behaviour of central bankers dictates the price of money. The behaviour of those making investment decisions will govern where markets go.
These sorts of observations may well have been what prompted Warren Buffett’s business partner, Charlie Munger, when asked about economics, to comment: “If it isn’t behavioural, what the hell is it?” Yet the study of behavioural economics, finance and investing is still, in many respects, in its infancy.
It is hard, if not impossible, to build complex human behaviour into economic models. For such models to be consistent, it has to be assumed that consumers are able to assess the utility of each option and to choose the one with the highest benefit. The real world is not that neat.
For humans to become high functioning beings, we needed to simplify. Imagine how hard it would be if we were able to perceive in our consciousness everything around us – every sound, every smell, every movement. Bacteria do this, but there came a point in our evolution when we needed to start filtering in order to hone in on the important stuff. More focus and thus less clutter enabled us to evolve further. (If only teenagers realised this.)
Human beings and perhaps other species before them developed mental shortcuts to approximate what was going on around them in order to prevent them being overwhelmed with detail. Called ‘cognitive biases’, these shortcuts generally help us make decisions faster and thus more effectively, but far from flawlessly.
Wikipedia lists 187 cognitive biases to which we human beings are prone. Some of these are closely related but mostly they are distinct. A perhaps familiar cognitive bias is overconfidence, which helps us to convince others that we are better than we actually are. This has helped, and continues to help us, attract a healthy mate or get promoted within the tribe, but in some modern day pursuits it can be counterproductive.
Such pursuits tend to be those that require a good dose of humility. One such pursuit is golf, where perfection is elusive if not unachievable, and the course is there to make you look like a fool. Another one, of course, is investing. Since it is hard to know for sure whether good investment performance is due to luck or judgment, it is best to assume the former.
Human emotions such as fear, anger, sadness and joy are similar to cognitive biases in that they also help us survive and thrive.
In the world of investing however, emotions can be seriously damaging. During a bear market, the more markets fall, the more fearful we become. We see big portfolio losses as a threat to a comfortable retirement, perhaps even to our very existence. So, we cut our losses and run. Our emotions are too strong to allow us to rationalise the situation.
Another human behavioural trait is to want good things to last forever. We know that the party will end – after all, they always do – and yet we tell ourselves it won’t. We even go so far as to construct reasons why it will go on and on. In other words, why it is different this time.
Recently, the likes of former Fed governor Ben Bernanke and former US Treasury secretary Larry Summers have been suggesting, respectively, that an inverted yield curve no longer signals a looming recession and that a tight labour market no longer leads to rising inflation.
It may be time to start preparing for the next bear. But remember, the expert advice is to stand your ground.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.