How does an investor learn to be an investor? To answer this question we must go back to a more general question: how does our brain learn?
The answer is very complex and it has been proven that there are many learning mechanisms, but I’ll try to answer it through the interesting angle of instrumental conditioning. Many of us will remember an experiment that consisted of a box with a button, a feed dispenser and a rat inside, where the rat would press the button and receive a portion of food. The animal, through learning by conditioning, pressed the button every time it wanted to receive food.
This isn’t far removed from how we humans learn. It’s essentially a form of learning whereby a subject is more likely to repeat a certain behaviour if it’s followed by a positive consequence (reinforcement) rather than a negative one (punishment). In short, by trial and error we learn to do what leads to an appealing consequence. In addition, the larger and more repeated the reinforcement, the greater the likelihood that a given behaviour will be repeated.
As investors, our first reinforcement will be profitability and, by instrumental learning, we will invest by trial and error in what brings us the best returns, simplifying the landscape in which many other stimuli complicate things for us, such as the environment, our emotional and economic situation, etc. In this regard, the higher the expected return, the greater the likelihood of investing again in that financial instrument.
If we flip the scenario around, we see that the opposite is true: Negative returns or unpleasant experiences will act as negative reinforcement and lead us to try and escape the situation, exhibit avoidance behaviours, or could even lead to the outright abandonment of said investments for those investors who have had bad experiences and have decided to stop being investors.
In addition to what I’ve mentioned previously, emotional factors play a major role in any scenario involving decisions and learning, especially in investment, and are really important in decision making.
During those years of experience working with investors, we’ve found that investors repeat some of the decisions derived from behaviour that is more emotional than rational, specifically because all kinds of factors (social, cultural, economic, emotional, etc.) constantly influence our investment behaviour. Moreover, investors don’t always have the best conditions to make decisions, e.g. information, environmental circumstances, news, etc.
When deciding in what or how to invest, a number of biased mechanisms will inevitably be triggered that ultimately lead to an illogical decision.
Furthermore, in order to explain investor behaviour, we have to delve into behavioural psychology or social psychology, which, for a relatively short time now, has accompanied the study of these types of behavioural patterns in mathematics or economics, as well as decision theory or the well-known indifference curve.
A number of investment advice manuals have been published that warn us or inform us of the importance of biases and that warn us of the danger they pose for decision making, but in this post I’d like to focus on some of the most frequent biases we see in the behaviour of our investors, how to identify them and be able to make the best possible decision.
Firstly, we must avoid one of the most common biases in the investment world that leads us to engage in impulsive decision making that is sometimes not aligned with our principles as investors. This is the so-called herd effect and in short is acting according to what others say or do, without analysing whether we’re prepared for it or whether it will be a good investment, accepting the reasoning of the majority as valid without questioning whether it’s correct.
To explain the reason for this bias, we should mention our now well-known mirror neurons, i.e. those specialising in understanding the behaviour of others and interpreting how they feel, leading to mimicking how others act.
This bias leads the investor to increase positions in bull markets or to close them when panic takes hold of the markets.
Secondly, we often observe overconfidence, which is an excess of optimism or self-confidence, when investors think that they know how markets work and are convinced that they can predict market movements in the short term.
This usually leads them to try to predict what will happen in the short to medium term in the markets and to trade in and out of equities when they think they’re confident that it’s the best time to do so. This rarely brings the best results for investors and we’ll always try to discourage them from doing so.
We see this very clearly both in cases where an investor decides to increase positions and even more so in some safe moves into fixed income, trying to predict that a time of widespread falls is on the way.
Furthermore, the so-called status quo bias leads to decision paralysis by thinking that staying as we are will be better than taking a specific position, ending up with a wait-and-see stance, sometimes as a result of information overload. As a result of this bias, we fail to take advantage of good market opportunities to take positions, falling victim to “analysis paralysis”.
To finish analysing the biases that we engage in the most, I’d like to mention the anchoring bias, which involves giving more weight to the first piece of information we receive about a certain product, without giving the same importance to the information we receive later.
This is yet another consequence of the excess of information to which we investors are exposed, as well as the tendency of various media, blogs, forums, etc. to always present success stories and ignore or neglect cases of failure using the same methods. Think how many times we’ve seen, read or heard how well a certain public figure, friend or neighbour is doing, but how few times we’re shown the cases in which they didn’t do so well…
Can we avoid falling prey to biases or at least mitigate their effect on our investment decisions? As always, the first thing to do is to know how they work and how to recognise them in yourself. If you’ve been following our blog and our social media, you’ll see that we put a lot of emphasis on biases so that they become more and more recognisable and investors can overcome them.
Making an emotionless decision is difficult if not impossible, but I challenge you to start identifying all these patterns and to do so, pay attention to this blog and to the news that we at Cobas AM bring you, so that as investors we’re increasingly aware and ultimately aligned with a long-term philosophy.