At the end of the 19th century, Friedrich Nietzsche penned one of those ideas that everyone has heard: we are our own worst enemy. Perhaps the iconoclastic German philosopher was trying to teach us something about investing? Unlikely, but the warning makes sense when we think about the biases that influence our investment decisions. Specifically, the conflict between analysis and intuition when it comes to investing.
In “Your Money and Your Brain”, journalist Jason Zweig explores the intersection of psychology and finance. The book focuses on how human emotions and cognition affect our financial decisions and how investors can understand and overcome the emotional biases that often lead them to make irrational decisions in the financial realm.
And believe me, examples of irrational investment decisions are not in short supply. Sometimes, these decisions disguise themselves as good hunches. Zweig explains that “professional traders regularly move billions of dollars a day based on ‘what my gut tells me.’” George Soros, one of the most successful investors, “considers selling his stocks when he has back pain”.
Irrationality can sometimes lead to significant financial losses. During the dot-com bubble, investments in the Nasdaq Composite index grew by 800%, only to fall by 740% within two years. Faith in new tech companies drove stock prices up. In some cases, simply changing a company’s name to include “dot-com” or “.net” was enough to trigger madness. How is this possible?
The ‘two brains’ of investors
The explanation has to do with how different parts of the brain relate to financial decisions. The human brain is composed of various regions and systems that play specific roles in decision-making. As Jason Zweig explains in the book, two parts of the brain are particularly relevant in investment decision-making.
On one hand, the emotional brain (the limbic system) is associated with emotions and plays a crucial role in our emotional responses to situations. In the financial domain, the limbic system can be responsible for reactions like fear of losses and the euphoria of gains. In fact, we tend to feel the fear of losing money more intensely than the satisfaction of earning it.
On the other hand, the rational brain (the prefrontal cortex) is associated with logical thinking, rational decision-making, and long-term planning. However, when it comes to financial decisions, the prefrontal cortex can be affected by the influence of the limbic system. Intense emotions can make it difficult for this part of the brain to function optimally, leading to impulsive or irrational decisions.
Problems arise when we let intuition (emotional brain) make decisions that should be filtered through analysis (rational brain) first. This is what happened in the dot-com bubble. “People who bought these stocks didn’t analyze the underlying business; instead, they followed a feeling, a sensation, a hunch,” explains Zweig.
But you don’t have to think of catastrophic bubbles to see the tug-of-war between these two ways of thinking. For example, the emotional brain focuses more on what changes than what remains stable. That’s why sometimes we attach more importance to absolute changes in the value of an index or a stock than to its percentage change. Or we pay more attention to a fund’s recent performance than its long-term results.
How to invest better: with analysis or intuition?
The rational brain intervenes, for example, to answer the question of whether my investment portfolio is adequately diversified. Analysis is necessary, but it is not foolproof. As Zweig relates, overconfidence in our rational brain also leads to errors.
There are people who spend two or three hours a day analyzing stocks. “They are often convinced they have discovered a unique statistical secret that will allow them to beat the market. Because they have drowned their intuition, their analysis fails to alert them to the most obvious fact of all: at least 100 million other investors can see the same data, stripping most of its value,” explains Zweig.
So, there is no dumb brain and smart brain. Both systems function differently, and the key is knowing how to combine their strengths. Zweig suggests some tips for combining analysis and intuition when investing:
- Trust your gut. Before investing, “read the documents that may reveal the character of the company’s leaders, the annual statement of powers, and the president’s letter to shareholders in the annual report, with an eye open to feeling emotions.” If something makes you suspicious, delay your decision.
- Stay calm. It’s hard to predict how a company or sector will evolve in the future. Don’t be swayed by messages like “cryptocurrencies will change the world” or “oil prices are on the rise” without analyzing them in detail.
- Ask other questions. Before making a decision, ask questions like “how do I know?” or “what’s the evidence?” Or imagine that it’s a friend, not you, who is about to make the decision. Would you recommend it, or would you tell them to think it over?
- Set clear rules. As Benjamin Graham said, “people don’t need extraordinary insight or intelligence. What is needed is to adopt simple rules and stick to them.” For example, set limits on how much to invest in a single stock or under what conditions to sell an asset.
- Count to ten. Your mood can influence your investment decisions. If you’re about to make an important decision, take a walk, put it off until the next day, or discuss it with someone whose judgment you trust.
- Focus on value. “It is not uncommon for a stock’s price to change a thousand times in a single trading day, but in the real world, a company’s value hardly changes from one day to the next.” Take a moment to think if you understand the business model well and how it might look ten years from now.
