More on emotion driven investment decisions

This quote below from an expert at Hargreaves Lansdown is so relevant to my recent alert about investing and ‘The Laws of Human Nature’ that I have reprinted it below.

“We’d like to think that we’re driven solely by logic and evidence when it comes to financial matters, but this isn’t always the case.

We’re all prone to influences and bias in our everyday lives, not least when investing. In my role as a Financial Adviser, I help clients on a daily basis with their finances and investments and get to see some of these first-hand.

Behavioural finance, psychology of investing, works on the assumption that people aren’t always rational investors. It argues that we’re often guided by emotional judgements that can run counter to what logic dictates. 

Below I highlight four common patterns of thinking that might affect your investment decisions, and how you can try to overcome them. 

This article is not personal advice. If you’re unsure, please seek advice. All investments fall as well as rise in value, so you could get back less than you invest. 

1. Loss aversion 

A purely rational person should be just as happy with a profit of £100 as they would be unhappy with a loss of £100. But research suggests that the pain of a loss is felt more strongly than the pleasure of a gain. 

This can result in a tendency to not want to sell an investment at a loss. Clearly, this is driven by emotion and not entirely by rational decision making. 

This is linked to ‘the sunk cost fallacy’. The action of sticking with a loss because you’re already invested. Think of it a bit like buying a cinema ticket for a really bad film but rather than leaving the cinema, you stick it out because you’ve paid for the ticket. 

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Tip: One way to overcome the ‘fear’ of selling at a loss (when it’s appropriate, of course) is to ask yourself, if you didn’t already hold that investment, would you buy it today? 

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2. Hindsight bias 

In the aftermath of an event, it’s easy to find experts who can provide detailed explanations as to why an event happened. This can cause us to believe an event was easy to spot and therefore avoidable. In reality this is rarely the case. 

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Tip: Try not to focus too much on macroeconomic events you can’t control and short-term thinking. It’s far more important to take a step back and think about what’s happening in your world. Think about the long term, and give your investments plenty of time to ride out shorter-term market fluctuations. 

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3. Herding 

This concept refers to the tendency for people to ‘follow the crowd’. 

The Bitcoin craze is a great example. But perhaps the most famous example of this phenomenon was during the dot-com bubble that occurred around the start of the millennium. 

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Tip: When investing, it’s important to build a well-balanced and diversified portfolio. Make sure you’re not putting all your eggs in one basket. 

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4. Confirmation bias

These days, there’s so much information out there, it can be hard to know what to pay attention to. 

Sometimes we’ll actively look for information that simply confirms what we already believe. For example, you might have an idea in mind for your next financial move. When you research it, you ignore the nine articles which say it might not be such a good idea, and listen to the one which says you should go for it.

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Tip: Most financial decisions are too big to be made on gut feeling. Get some balanced views and don’t ignore the experts. 

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The above are not my ideas but those of a financial adviser writing for Hargreaves Lansdown but he makes some interesting points. The main one I want to focus on here is his second one about hindsight bias. It ties in with my warning that when we look at my charts and the pretty lines I draw on them we have the advantage of 20:20 hindsight. If I knew that my charts, lines and signals were going to work as well in the future as they appear to have done in the past I would already be placing my order for an Aston Martin DBX 707. This is the first SUV from Aston Martin and a car that would go perfectly with my N. Peal 007 gloves and the 007 way of speaking that I apparently have which causes the instructors so much amusement at my local gym that they call me 007 (as in posh) and fall about laughing when I say something like ‘oh hello’. If you are posh try saying that and not sounding posh.

There are two problems with operating my signals based trading system. The first is that it is harder to do in real time than with hindsight. If we knew that the Nasdaq 100 was going to double in the next three years it would make our decisions easier to take. As it happens my best guess is that the Nasdaq 100 will double in the next three years so that is a helpful thought, especially when averaging down on something like QQQ3.

The second and bigger problem is to actually follow my trading system. All the things that this guy is talking about above and which Robert Greene referenced in his talk about the Laws of Human Nature make it surprisingly hard to do. For some reason even though we know what to do when push comes to shove we don’t do it.

So the real key to being a successful investor is iron discipline. We need to think of ourselves as the remorseless Prussian army taking on those emotional Frenchies in 1870. The Prussians won, decisively, even though it was the French who declared war. You can see why the French are a bit paranoid about the Germans because left to their own devices they managed to lose the Anglo-Prussian war and would have lost the First World War and the Second World War but when did we last lose a war. The only example I can think of is when we got antsy about the Suez Canal and who were are partners in that adventure. Just saying.

I don’t use the Dow Jones Industrials index that much these days because it is just 30 shares and is calculated in a rather ridiculous way but it still gives the flavour of what is happening on Wall Street and there is an ETF (DIA) which tracks it. What you can see is that over time my Coppock-based blue to red signals have done an. excellent job in keeping you in the market for periods of rising prices and out the rest of the time. The weakness is that for much of the rest of the time the index was still rising. Coppock is not perfect but it does make sure you win.

The next level is to combine Coppock with my other signals (trend line breaks, moving averages, balance of shares in the QV table looking positive versus those looking negative) and use that to fine tune our decision making.

At the moment the charts are clear, nothing or almost nothing, is saying buy including the Dow Jones. It gets trickier when we move into that no-man’s land where markets are on the turn and we might have a signal but we are still not quite sure. My instinct is to err on the side of caution and not declare a buy until we are sure (don’t shoot until we see the whites of their eyes). The great thing about markets is that when they do finally change direction they often move an astonishingly long way.

A commentator I respect says US markets are massively oversold and the US economy is still in great shape. If he is right the bull market will resume with a vengeance but that doesn’t mean we have to jump the gun. We may not buy at the bottom but whoever does except by sheer luck but we will buy into a market which is going up.

Just remember, science and logic, not emotion and the seat of the pants.