Don't let fear distort your thinking

Highlights in this issue:

• Emotions stand in your way of success on the markets...
• What type of thinker are you...?
• Put your foot down to fear... and more...

Ever wondered how your brain reacts when confronted with fear? Regardless of whether you're trading for the short-term or investing for the long-term, it's something you have to learn to contend with and not be ruled by.

This brings me swiftly to today's issue of the Investment Academy. Tim Bennett from MoneyWeek wrote a fantastic article recently about the fear factor on investors and I just had to share it with you. Quite incredible!

Anyway, good luck with the quiz and over to Tim...

Imagine there’s a cobra coiled inside a sealed glass box one metre away from you. As you approach, the snake rears up. What do you do? You leap back, of course. This is what psychologists call your brain’s "X-system", or "fight or flight" reflex, kicking in. The argument is that over the course of our evolution, this is what got us out of trouble. A rapid, reflex response to fear “carried a very low cost to a false positive”, as James Montier at Société Générale puts it – at worst we wasted energy running away from danger. That’s a price worth paying compared to “the potentially fatal cost of a false negative” – being bitten or eaten. The trouble is, says Montier, sometimes it’s better to think first and react later – to use our more logical, rational and slower "C-system". And a bear market – like the one we’re in now – is one of those times.

Emotional investors miss bargains

X-system responses are great when you’re in physical danger. But they can let you down when investing. Take an experiment done by Shiv, Loewenstein, Damasio and Damasio in 2005. They set up a game lasting 20 rounds. You start with $20. At the start of each round, you have two choices. Either you invest $1 or you don’t. A coin is then flipped. A heads call wins you $2.50, as long as you invested. A tails flip means you lose your $1. That process is repeated 20 times, at the end of which you've made 20 decisions. So what’s the correct strategy? A rational investor would invest every time. That’s because the expected, or probable, payout per round is $1.25 ($2.50 x 50% + $0 x 50%) and the result from each has no bearing on the next. By extension, your expected outcome from 20 rounds is $25. That beats not investing to keep just $20 (which you have an 87% chance of making anyway by playing every round). Yet, when the experiment was run, most investors invested less than 40% of the time after a losing round. And the longer the game went on, the more anxious and risk averse they became. This is irrational X-system, rather than logical C-system, investing at work. So fear of losing money can end up costing you even more.

And it’s not just retail investors who're prey to X-system thinking. Shane Frederik at the Massachusetts Institute of Technology created a three-question test (see below) on which most investors could score well by engaging slower, C-system thinking. Montier gave the test blind to more than 700 fund managers. Only 40% got all three questions right. It’s not that 60% of fund managers are less able, but that they struggle to override their snap responses. Those same responses can lead sound stock-pickers to miss out on bargains.

Resist your X-system

In short, fear of losing money can hold us back from investing (particularly if we’ve already lost money in the markets), even when our rational brain is telling us that stocks look cheap. So, what to do about it? First, make sure you have a strategy. If your chosen criteria, whatever they are – perhaps low price/earnings, price/book value, or price/cash-flow ratios – are flashing "buy", then go for it. Have an exit strategy too.

Think about the return you want to make and how much you're prepared to lose before you sell. By making the investment process as mechanical as possible, there’s less chance that you’ll be held hostage by your emotions. Then avoid situations that'll kick your X-system into action. Be selective about the news you read – grim headlines can make you panic. Instead, monitor your portfolio at set intervals, say quarterly. This will stop you panic-selling after a few days or weeks, racking up broking charges in the process.

Are you an X- or a C-system thinker?

Some people are very good at overriding their X-systems, but most aren't. Here’s a test devised by Shane Frederik at the Massachusetts Institute of Technology to show that people tend to think from the gut first and engage their brain later (answers below).
1. A bat and a ball together cost $1.10. The bat costs a dollar more than the ball. How much does the ball cost?
2. It takes five machines five minutes to make five widgets. How long will it take 100 machines to make 100 widgets?
3. A lake contains a patch of lilies. The patch doubles in size daily. If it takes 48 days for the patch to cover the lake, how long does it take to cover half of it?

Your X-system would give you answers of 10 cents, 100 minutes and 24 days. All wrong. 1. Five cents. 2. Five minutes – no matter how many machines are involved, they all take five minutes per widget. 3. 47 days. The lily pad then doubles on day 48 to cover the pond.

An article definitely providing food for thought!

Happy trading!

Julie Brownlee
for the Investment Academy

P.S. Don't forget to get tweeting!