Bussiness News
Investing Basics: Six Ways to Outsmart Your Ape Brain
By
Lisa LaMotta Mar 18, 2010 2:00 pm
Don't let these common behaviors drive your investing decisions.
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Let's face it, it's impossible to override innate human instincts when making investing decisions. Talking about money, deciding how to spend it, anticipating reward, or suffering financial losses all activate different emotional centers in our brain, a phenomenon now illustrated by experiments using MRI technology. Scientists at Duke University have even found that just by analyzing which areas of the brain light up in reaction to risks or rewards, they could predict who among their subjects would be most likely to employ specific money strategies.
Over time, experts have identified the most common investing biases that stem from this primitive wiring -- the same inescapable "ape brain" functions that once kept us alive in the jungle. While some of these behaviors are more obvious in active traders, even casual investors can get caught up in emotions, says Smita Sadana, founder and chief executive of Sunrise Capital in Austin, Texas. And absolutely no one is immune to them. But once we know that we're guilty of committing an emotional bias, it can be easy to course correct -- or at least open our eyes to what we're doing.
1. Don't be a Victim of Your Last Success or Failure
Avoid: Recency Bias
One of the most common "ape brain" mistakes is to focus on your last few decisions rather than take the big picture into account, especially when your investments have taken a turn for the worse. "A few losing calls will cause precious many months of winning calls to be forgotten, since we tend to place more relevance on recent activities," says Sadana. "This is a human defense mechanism that helps us cope with the past and pay more attention to recent activities, but in investing, such doubt causes grave results since it can impact the decision-making process."
The Fix: Sadana recommends reassessing your action by taking a step away and allowing yourself to view the long-term situation in your portfolio.
2. Give Credit Where Credit's Due
Avoid: Attribution Bias
Everyone likes to think that the good investing decisions were the result of their own smart thinking, and that the blame for the bad decisions (or losses) lies with someone else. But often, we really shouldn't take the credit for either. "We tend to attribute positive outcomes to ourselves and negative outcomes to chance or outside factors," says psychologist Brett Steenbarger, author of the blog TraderFeed. "Obviously, that can distort our decision making."
The Fix: Take stock of everything you do at the end of each month or quarter and write down all of the things you did right, the things you did wrong, and what you can change, says Steenbarger. "Taking ownership of your strengths and weaknesses can help you become mindful of your trading processes," he adds.
3. Remember to Get a Range of Opinions
Avoid: Diagnosis Bias
Each person views the world through their personal filter -- some are especially rosy, while others can be negative or pessimistic. The shade of your filter can have a major impact on how you invest or trade. According to Sadana, bulls tend to surround themselves with other bulls, while ignoring the bear view, and vice versa. "It's an evolutionary trait, but unfortunately it can inject subjectivity in our diagnosis of the situation: We might not see the positive market action due to the fact that we paid attention to overly bearish commentary," says Sadana.
The Fix: Try to bookmark websites and watch segments that are authored by people who have a different investing style than your own. Bring balance back to your worldview by surrounding yourself with a mix of commentary.
4. Don't Get Hooked on the Fix
Avoid: Addiction Bias
This is a behavior most common among traders or casual investors who dabble in stocks. It's easy to fall into patterns and start getting addicted to trading the same stocks day in and day out. "As traders, we often hold onto the memories of our trades," says Sadana, "any subsequent positions in these stocks are often colored by those memories." The best way to kick an addiction to familiar stocks is to keep a trading log to give you a better idea of how your portfolio is performing overall and to more easily identify the stocks that might be pulling you down at any given time.
The Fix: Sadana suggests creating a set of rules for your trades -- set a minimum time period for staying out of a certain stock so that you don't take up the position again too quickly.
5. Stand Alone From the Pack
Avoid: Herding Bias
Some of us follow the crowd our whole lives, while others find a way to stand out -- when it comes to investing it's better to stray from the pack. "When everybody is looking in the same direction, no one is really seeing," says Dr. Janice Dorn, a board-certified psychiatrist and active trader based in Phoenix, Arizona, who adds that this bias comes from when we were cavemen and gathered in packs to survive. "Those investors that succeed are the ones that are able to look over the heads of the herd."
The Fix: Dorn says not to be afraid to use contrary thinking. Use times when there is massive buying or selling on the market to evaluate whether or not the crowd is making sense; pay particular attention to whether the trading action looks like a top or a bottom.
6. Remove Temptation
Avoid: Restraint Bias
Oscar Wilde said, "I can resist anything except temptation," and he was probably right. Like that piece of chocolate cake in the company cafeteria or the newest gadget from Apple (AAPL), some stocks are just hard to stay away from, even if you know that they won't mesh well with the rest of your portfolio. "At such times, we overestimate our capability to resist temptation," says Sadana, explaining restraint bias, or an inflated sense of self-control. "And hence, avoiding temptation is easier than overcoming it."
The Fix: The best way to overcome a restraint bias is to completely stay away from stocks that you know you shouldn't be investing in. That means avoiding any literature on those stocks, turning down the television when they're discussed, and training your brain to avoid the subject in its entirety.
Over time, experts have identified the most common investing biases that stem from this primitive wiring -- the same inescapable "ape brain" functions that once kept us alive in the jungle. While some of these behaviors are more obvious in active traders, even casual investors can get caught up in emotions, says Smita Sadana, founder and chief executive of Sunrise Capital in Austin, Texas. And absolutely no one is immune to them. But once we know that we're guilty of committing an emotional bias, it can be easy to course correct -- or at least open our eyes to what we're doing.
1. Don't be a Victim of Your Last Success or Failure
Avoid: Recency Bias
One of the most common "ape brain" mistakes is to focus on your last few decisions rather than take the big picture into account, especially when your investments have taken a turn for the worse. "A few losing calls will cause precious many months of winning calls to be forgotten, since we tend to place more relevance on recent activities," says Sadana. "This is a human defense mechanism that helps us cope with the past and pay more attention to recent activities, but in investing, such doubt causes grave results since it can impact the decision-making process."
The Fix: Sadana recommends reassessing your action by taking a step away and allowing yourself to view the long-term situation in your portfolio.
2. Give Credit Where Credit's Due
Avoid: Attribution Bias
Everyone likes to think that the good investing decisions were the result of their own smart thinking, and that the blame for the bad decisions (or losses) lies with someone else. But often, we really shouldn't take the credit for either. "We tend to attribute positive outcomes to ourselves and negative outcomes to chance or outside factors," says psychologist Brett Steenbarger, author of the blog TraderFeed. "Obviously, that can distort our decision making."
The Fix: Take stock of everything you do at the end of each month or quarter and write down all of the things you did right, the things you did wrong, and what you can change, says Steenbarger. "Taking ownership of your strengths and weaknesses can help you become mindful of your trading processes," he adds.
3. Remember to Get a Range of Opinions
Avoid: Diagnosis Bias
Each person views the world through their personal filter -- some are especially rosy, while others can be negative or pessimistic. The shade of your filter can have a major impact on how you invest or trade. According to Sadana, bulls tend to surround themselves with other bulls, while ignoring the bear view, and vice versa. "It's an evolutionary trait, but unfortunately it can inject subjectivity in our diagnosis of the situation: We might not see the positive market action due to the fact that we paid attention to overly bearish commentary," says Sadana.
The Fix: Try to bookmark websites and watch segments that are authored by people who have a different investing style than your own. Bring balance back to your worldview by surrounding yourself with a mix of commentary.
4. Don't Get Hooked on the Fix
Avoid: Addiction Bias
This is a behavior most common among traders or casual investors who dabble in stocks. It's easy to fall into patterns and start getting addicted to trading the same stocks day in and day out. "As traders, we often hold onto the memories of our trades," says Sadana, "any subsequent positions in these stocks are often colored by those memories." The best way to kick an addiction to familiar stocks is to keep a trading log to give you a better idea of how your portfolio is performing overall and to more easily identify the stocks that might be pulling you down at any given time.
The Fix: Sadana suggests creating a set of rules for your trades -- set a minimum time period for staying out of a certain stock so that you don't take up the position again too quickly.
5. Stand Alone From the Pack
Avoid: Herding Bias
Some of us follow the crowd our whole lives, while others find a way to stand out -- when it comes to investing it's better to stray from the pack. "When everybody is looking in the same direction, no one is really seeing," says Dr. Janice Dorn, a board-certified psychiatrist and active trader based in Phoenix, Arizona, who adds that this bias comes from when we were cavemen and gathered in packs to survive. "Those investors that succeed are the ones that are able to look over the heads of the herd."
The Fix: Dorn says not to be afraid to use contrary thinking. Use times when there is massive buying or selling on the market to evaluate whether or not the crowd is making sense; pay particular attention to whether the trading action looks like a top or a bottom.
6. Remove Temptation
Avoid: Restraint Bias
Oscar Wilde said, "I can resist anything except temptation," and he was probably right. Like that piece of chocolate cake in the company cafeteria or the newest gadget from Apple (AAPL), some stocks are just hard to stay away from, even if you know that they won't mesh well with the rest of your portfolio. "At such times, we overestimate our capability to resist temptation," says Sadana, explaining restraint bias, or an inflated sense of self-control. "And hence, avoiding temptation is easier than overcoming it."
The Fix: The best way to overcome a restraint bias is to completely stay away from stocks that you know you shouldn't be investing in. That means avoiding any literature on those stocks, turning down the television when they're discussed, and training your brain to avoid the subject in its entirety.
No positions in stocks mentioned.
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