Why bad choices feel good
INVESTING: HUMANS CONSTRUCT ARGUMENTS TO JUSTIFY EMOTIONS
Your emotional state changes the next investment decision you make.
Anybody who has been in the markets for any length of time knows returns don’t come in a straight line. We constantly face the ups and downs of market cycles.
Yet we still don’t deal with it very well. Often, we’re more influenced by how our investments behave on the way to reaching a specific point, than what that point actually is.
Consider two individuals who both invest R100 000 in different unit trusts at the same time. Graph 1 shows how they perform over three years.
Rationally, at the end of this period, both investors should be equally happy with how their money performed, having achieved the same outcome.
However, we suspect that if these two individuals had been tracking their investments closely, they wouldn’t feel the same satisfaction. As Greg Davies, head of behavioural finance at Oxford Risk told the Momentum Investment roadshow: “We feel that the journey we have been on matters.”
The next step
How you’re feeling implicates what you do next. “Your emotional state changes the next investment decision you make.”
In the example, both investors gained 35% from where they started. Investor A, however, is 31% down from the highest level they achieved. Investor B is up 57% from their low.
It would be reasonable for Investor A to feel disappointed, even apprehensive, about where the investment’s going, and for Investor B to feel positive.
Fundamentals aside, it would be far more likely for Investor A to exit the investment at this point than Investor B. Similarly, if they were each given another R100 000 to invest, Investor B would be far more likely to add it to their current investment. Investor A would find that harder to do.
Trusting your gut
Remember, financially, these two investors are in exactly the same position.
Yet the decisions they might make are potentially completely different due to their recent past experience.
Davies explains: “As much as we might like to think we make every investment decision by rationally weighing up the risk-andreturn trade-off ... an awful lot ... is based on the simple question: How do I feel about this right now; what does my gut tell me?”
This is one of the great challenges in investing: we are predisposed to making decisions based on what makes us feel better.
Hence many investors sell out and lock in their losses during a market crash: they can no longer take the discomfort of seeing the value of their investments falling.
It’s equally why investors flooded into Bitcoin in 2017’s second half – it was too uncomfortable to sit on the sidelines when they heard about others making a killing.
Convincing ourselves
We want to avoid discomfort so much we can even come up with what seem like rational reasons for doing so. Davies uses the late 1990s’ DotCom bubble to show we can produce apparently sound arguments for anything when we really want to believe it.
“There were books coming out at the time saying the Dow [Jones Industrial Average] is going to 60 000, or 80 000, even 100 000 ... you would think that these books would just be nonsense. Except they’re not.
“They are fairly well written, well-reasoned, articulate, complex, sophisticated arguments for complete nonsense. Because, as humans, if we have decided we want to believe something, we are capable of constructing incredibly sophisticated arguments as to why we are right ... because we need to justify the way we feel.”
This can be seriously detrimental to our long-term objectives. The comfortable decision in the moment and the right decision for securing the best longterm outcomes are often at odds.