The Sketchbook of Wisdom: A Hand-Crafted Manual on the Pursuit of Wealth and Good Life.
This is a masterpiece.
– Morgan Housel, Author, The Psychology of Money
The Internet is brimming with resources that proclaim, “nearly everything you believed about investing is incorrect.” However, there are far fewer that aim to help you become a better investor by revealing that “much of what you think you know about yourself is inaccurate.” In this series of posts on the psychology of investing, I will take you through the journey of the biggest psychological flaws we suffer from that causes us to make dumb mistakes in investing. This series is part of a joint investor education initiative between Safal Niveshak and DSP Mutual Fund.
Imagine you are one of our cave-dwelling ancestors, minding your own business, when suddenly a tiger appears. Do you –
- Carefully weigh the pros and cons of running vs fighting?
- Calculate the statistical probability of survival based on past tiger encounters?
- Scream and run faster than Usain Bolt?
If you chose C, congratulations! You are alive (well, your ancestors were), and you are also the proud owner of a brain that is about as well-suited for modern investing as a hammer is for performing brain surgery.
Well, this is what the world of behavioural finance looks like, where your inner caveman is constantly trying to protect you from predators that do not exist and hoard resources you do not need. This is because we still have our Stone Age brains installed on the top of our heads, which are now wreaking havoc on our modern investment portfolios.
Confused? Let’s start from the start.
The Evolutionary Mismatch: When Mammoths Meet Mutual Funds
You see, our brains evolved over millions of years to help us survive in a world where danger lurked behind every bush, and our next meal was never guaranteed. In such an environment, immediate and instinctive reactions were important, because hesitation could mean death, and over-analyzing a situation could cost us our lives.
Our ancestors needed to make quick decisions based on limited information, relying on gut feelings and rapid assessments rather than deliberate, logical reasoning.
Fast forward to today, and we are using the same brain to navigate complex financial markets. Our survival-driven mental wiring, optimized for a world of short-term threats and opportunities, now struggles to adapt to the complex, abstract nature of long-term financial decision-making in today’s world. This is like trying to play chess with a checkers set – the pieces just don’t quite fit.
Daniel Kahneman, also known as the father of behavioural economics, explained this mismatch in his wonderful book Thinking Fast and Slow, which I highly recommend. He did this through his concept of System 1 and System 2 thinking.
System 1 is our fast, intuitive, emotional brain – great for dodging predators, not so great for evaluating P/E ratios. It is the part of our mind that jumps to conclusions, makes snap judgments, and acts on impulse, often driven by emotions like fear and greed.
System 2, on the other hand, is our slower, more analytical brain – perfect for complex decisions, but often too lazy to show up to work. It requires effort, concentration, and a willingness to think things through, which can be taxing and uncomfortable.
The result? We often rely on System 1 when making investment decisions, leading to impulsive actions, and overreactions to market swings. This disconnect between the quick, instinctive responses of System 1 and the deliberate, reasoned analysis of System 2 can cause us to make poor choices in investing, where patience, discipline, and careful evaluation are key to success.
But why does this happen? Well, the answer lies in…
Behavioural Biases: An Investor’s Worst Enemies
From understanding how our ancestral brains are turning our investment strategies into disasters, let’s turn a bit towards the mental traps that once helped our ancestors survive, but have now become pitfalls in the modern world of investing.
Scientists call these traps ‘biases’, which are simply the systematic errors in thinking that occur when we process and interpret information. These biases distort our perception of reality, leading us to make decisions that feel right in the moment but can have devastating consequences for our financial health.
Understanding these biases is the first step toward overcoming them and making more rational, informed decisions that align with our long-term investment goals.
Here are just three of them –
1. Loss Aversion: Remember that ugly vase you received on your wedding day from the aunt you loved the most? A few years have passed, that vase remains locked in your cabinet, but you cannot bear to throw it away. Why? That is loss aversion in action. Kahneman and his partner Amos Tversky showed that the pain of losing is about twice as strong as the pleasure of gaining. In investing, this leads to holding onto losing stocks like they are the last piece of dessert at a friend’s wedding buffet.
For our ancestors, losses were often fatal. Losing your spear could mean going hungry. But in investing, it means watching your portfolio go down faster than a rhino in quicksand.
2. Overconfidence: Have you ever met someone who thinks they are among the best drivers around or can easily beat the market? Well, that is overconfidence. Studies after studies have found that overconfident investors trade more frequently and earn lower returns, but who reads such studies?
Anyways, the evolutionary root for this bias lies in the confidence that helped our ancestors take risks and survive. But when it comes to investing, it helps us take some risks… and then go much beyond that by putting a large part of our savings in a hot stock recommended by your brother-in-law,who got that tip from a social media influencer.
3. Herding: Remember the 1999-2000 dot-com bubble, or the 2006-2008 power and infrastructure stocks bubble, or the small cap mania we have seen in the last 2-3 years? That is herding behaviour in action. We just love to follow the crowd, even if the crowd is running straight off a cliff.
Following the herd kept our ancestors safe from predators, but in investing, it keeps us away from independent thought and potential profits.
The Sketchbook of Wisdom: A Hand-Crafted Manual on the Pursuit of Wealth and Good Life.
This is a masterpiece.
– Morgan Housel, Author, The Psychology of Money
Anyway, as this series progresses, I am going to share more about these and other biases and how they hurt us while managing our money.
But for now, remember that our evolutionary heritage has gifted us with remarkable cognitive abilities, but also saddled us with biases that can lead to poor investment decisions.
Only when we understand these biases and develop ways to counteract them, we can evolve beyond our Stone Age instincts and make more rational, successful investment choices.
Of course, like I mentioned in the first post of this series, the goal is not to eliminate emotion from investing because that is neither possible nor desirable. Emotions like fear and greed can sometimes provide valuable intuitive insights. In fact, the world’s best investor, Warren Buffett, has often advised us to use these emotions to our advantage (“Be fearful when others are greedy and greedy when others are fearful”).
The key, however, is to develop an awareness of our emotional states and biases, allowing us to choose when to listen to our System 1 thinking and when to override it with more deliberative reasoning from System 2.
I have always believed successful investing is 1% intelligence and 99% behaviour. It is, basically, a game of understanding ourselves. And so, when we try to bridge the gap between our evolutionary past and our financial present, by learning how the former impacts the latter and what we can do about it, we can make better investment decisions and secure a more prosperous future.
This is what I will try to help you do through this series – bridge the gap between your evolutionary past and your financial present – that will help you learn more about and deal better with the biggest enemy in your investment journey – yourself.
Disclaimer: This article is published as part of a joint investor education initiative between Safal Niveshak and DSP Mutual Fund. All Mutual fund investors have to go through a one-time KYC (Know Your Customer) process. Investors should deal only with Registered Mutual Funds (‘RMF’). For more info on KYC, RMF & procedure to lodge/ redress any complaints, visit dspim.com/IEID. Mutual Fund investments are subject to market risks, read all scheme related documents