Getting In Touch With Our Inner Spock
As investors we all like to believe that we are smarter, shrewder and much more in tune with what’s happening in the world than the next guy. Our investment decisions are based on facts, a good understanding of the big picture and a clear grasp as to the reasons why our investments will out perform both the market and our contemporaries.
At least that is what we tell ourselves – unfortunately the reality is quite different.
As a general rule, the average investor has a very poor grasp of the current or future investment drivers, has no clear understanding of why they make the investment choices they do (other than it's what everyone else appears to be doing!), and as a result consistently under-performs the market.
The cause of this phenomenon is rooted in the way our brains handle decision making. From extensive research it appears that we have two systems in the brain, the first we can call the X-system and we can think of this as our emotional approach to decision making (the Dr McCoy system for those Star Trek fans). The second we can call the C-system and is a logical, methodical approach to problem solving (the Spock system). It seems that the X-system is our default setting with all decisions being made in this ‘quick and dirty’ manner for the sake of expediency, and in the majority of circumstances this system serves us well. But in situations where we need to be more thorough and thoughtful about our decision making we have to actually engage the C-system to override the default X-system, and this is where we can encounter problems, especially in the world of financial investment.
It should be clear to most of us that the key to successful investing is precisely the kind of 'Spock' type thinking that the C-system delivers - rational, logical, methodical and untroubled by human emotion. After all a good investment is a good investment irrespective of the emotion surrounding it. However you do not have to observe markets for too long to see that the majority of investors are anything but rational. It soon becomes clear that rational thought is the last thing on many investors minds as they chase the 'hot stocks' higher and sell the under performers down to ludicrous levels, and you would be wrong to suppose that this trait is only amongst the uninformed private investor. In my many years working for an Investment banking I witnessed some of the biggest funds on the planet acting like headless chickens, caught up in the emotional turmoil of the moment. The only difference being it wasn't their own money they were wasting!
Now let’s take a little detour and take a short test:
Easy yes? Designed
by Shane Frederick of Yale and known as the Cognitive Reflection Task (CRT),
these three simple questions show how effective we are at engaging our 'Spock'
system to override our default 'McKoy' system. They are amazingly effective
because each question offers a simple, obvious answer which is unfortunately
wrong, and it is only by engaging 'Spock mode' that we will get them correct.
Let's have a look at each question and see how you got on.
The obvious answers were:
Q1. 10c Q2. 100 minutes Q3 24 days
However the correct answers are:
Q1. 5c Q2. 5 minutes Q3 47 days
Don't feel too bad if you got one or all of them wrong. This test has been carried out on numerous groups of people and even with the best performing group (students from MIT), only 48% got all three questions correct.
This is quite staggering when you think about it. The fact that some of the smartest people on the planet can fail to answer three simple questions correctly, simply because they cannot override their emotional thinking process when required tells us an awful lot about why good long term investing can be so hard to achieve.
Still, now that you are aware of the problem, surely you can just force yourself into Spock mode and think rationally when the need arises? Well unfortunately it is not that easy. According to more research conducted into our ability to use willpower to force ourselves to comply, it seems that it acts similarly to a muscle in that it can become exhausted from overuse and we effectively run-out of reserves, returning to type.
So if we can't change our behaviour in spite of knowing how damaging it can be what can we do?
Fortunately there is an answer, and it is called 'having a system'
When many of the world's best investors are asked about their success, a common theme often appears. They have a predetermined set of parameters that the investment must meet, they decide on a buying price which if achieved gives them the investment at the right valuation, they conduct all their research 'in the cold light of day' away from the emotional pull of the markets, and finally, when the investment comes down to their predetermined price, they always buy it.
Now on paper this seems quite obvious, and indeed it is hardly rocket science. But anyone that has invested in financial markets will know just how hard it is to buy something that is going down. The sense of fear can be overwhelming and we rationalise our inaction away by convincing ourselves that we will be able to pick the bottom and have time to invest when the time is just right, except that picking the bottom is a rare event indeed and that more often than not investors miss out on the fleeting opportunity and end up seeing the price recover and having to pay more.
No matter how many times this happens to us, and we curse the missed opportunities and swear that the next time we will act, when the next time appears we are once again gripped with fear and the opportunity is lost.
This is why having a system and sticking to it is the key. You are able to mentally delegate your decision making to 'the system' and free yourself from the emotional turmoil involved in making it, and as long as your investment parameters are robust you will benefit in the long run.
As human beings we are poorly equipped to cope in the modern world of financial investment, but we are smart enough to understand the reasons why and do something about it, and bar becoming Vulcan, having a system and sticking to it is the best we've got.
As investors we all like to believe that we are smarter, shrewder and much more in tune with what’s happening in the world than the next guy. Our investment decisions are based on facts, a good understanding of the big picture and a clear grasp as to the reasons why our investments will out perform both the market and our contemporaries.
At least that is what we tell ourselves – unfortunately the reality is quite different.
As a general rule, the average investor has a very poor grasp of the current or future investment drivers, has no clear understanding of why they make the investment choices they do (other than it's what everyone else appears to be doing!), and as a result consistently under-performs the market.
The cause of this phenomenon is rooted in the way our brains handle decision making. From extensive research it appears that we have two systems in the brain, the first we can call the X-system and we can think of this as our emotional approach to decision making (the Dr McCoy system for those Star Trek fans). The second we can call the C-system and is a logical, methodical approach to problem solving (the Spock system). It seems that the X-system is our default setting with all decisions being made in this ‘quick and dirty’ manner for the sake of expediency, and in the majority of circumstances this system serves us well. But in situations where we need to be more thorough and thoughtful about our decision making we have to actually engage the C-system to override the default X-system, and this is where we can encounter problems, especially in the world of financial investment.
It should be clear to most of us that the key to successful investing is precisely the kind of 'Spock' type thinking that the C-system delivers - rational, logical, methodical and untroubled by human emotion. After all a good investment is a good investment irrespective of the emotion surrounding it. However you do not have to observe markets for too long to see that the majority of investors are anything but rational. It soon becomes clear that rational thought is the last thing on many investors minds as they chase the 'hot stocks' higher and sell the under performers down to ludicrous levels, and you would be wrong to suppose that this trait is only amongst the uninformed private investor. In my many years working for an Investment banking I witnessed some of the biggest funds on the planet acting like headless chickens, caught up in the emotional turmoil of the moment. The only difference being it wasn't their own money they were wasting!
Now let’s take a little detour and take a short test:
1. A bat and a ball together cost
$1.10 in total. The bat costs a dollar more than the ball. How much does the
ball cost?
2. If it takes five minutes for five
machines to make five widgets, how long would it take 100 machines to make 100
widgets?
3. In a lake there is a patch of lily
pads. Every day the patch doubles in size. If it takes 48 days for the patch to
cover the entire lake, how long will it take to cover half the lake?
Let's have a look at each question and see how you got on.
The obvious answers were:
Q1. 10c Q2. 100 minutes Q3 24 days
However the correct answers are:
Q1. 5c Q2. 5 minutes Q3 47 days
Don't feel too bad if you got one or all of them wrong. This test has been carried out on numerous groups of people and even with the best performing group (students from MIT), only 48% got all three questions correct.
This is quite staggering when you think about it. The fact that some of the smartest people on the planet can fail to answer three simple questions correctly, simply because they cannot override their emotional thinking process when required tells us an awful lot about why good long term investing can be so hard to achieve.
Still, now that you are aware of the problem, surely you can just force yourself into Spock mode and think rationally when the need arises? Well unfortunately it is not that easy. According to more research conducted into our ability to use willpower to force ourselves to comply, it seems that it acts similarly to a muscle in that it can become exhausted from overuse and we effectively run-out of reserves, returning to type.
So if we can't change our behaviour in spite of knowing how damaging it can be what can we do?
Fortunately there is an answer, and it is called 'having a system'
When many of the world's best investors are asked about their success, a common theme often appears. They have a predetermined set of parameters that the investment must meet, they decide on a buying price which if achieved gives them the investment at the right valuation, they conduct all their research 'in the cold light of day' away from the emotional pull of the markets, and finally, when the investment comes down to their predetermined price, they always buy it.
Now on paper this seems quite obvious, and indeed it is hardly rocket science. But anyone that has invested in financial markets will know just how hard it is to buy something that is going down. The sense of fear can be overwhelming and we rationalise our inaction away by convincing ourselves that we will be able to pick the bottom and have time to invest when the time is just right, except that picking the bottom is a rare event indeed and that more often than not investors miss out on the fleeting opportunity and end up seeing the price recover and having to pay more.
No matter how many times this happens to us, and we curse the missed opportunities and swear that the next time we will act, when the next time appears we are once again gripped with fear and the opportunity is lost.
This is why having a system and sticking to it is the key. You are able to mentally delegate your decision making to 'the system' and free yourself from the emotional turmoil involved in making it, and as long as your investment parameters are robust you will benefit in the long run.
As human beings we are poorly equipped to cope in the modern world of financial investment, but we are smart enough to understand the reasons why and do something about it, and bar becoming Vulcan, having a system and sticking to it is the best we've got.
