The Matrix was released in 1999 and grossed nearly half a billion dollars at the box office1. The story is about a protagonist named Neo, who feels that the world around him is not real. His relentless search for the truth eventually leads him to Morpheus, who claims to have the answers to all his questions.
Morpheus offers Neo a choice at their first meeting. Swallow the blue pill and go on living a lie, or take the red pill and learn the truth. I offer a similar choice to you.
Nearly all financial theory assumes that investors are rational and use logic and reasoning to make decisions. If you want to keep believing this, stop reading right now. But if you choose the red pill, it’s going to take you back to 2016.
That summer, the citizens of the U.K. voted to leave the European Union. The chart below shows the performance of the S&P 500 index over the following week after “Brexit” made headlines.
If someone were to only think within the confines of traditional financial theory to explain this chart, they would be at a loss. Brexit would have virtually zero impact on the U.S. economy, so no rational investor would sell because of it.
But someone sold. It’s right there in the chart. The S&P 500 fell over 5.3% in three days. This can only be explained by accepting that investors weren’t acting rationally. This wasn’t an isolated event, either. Fear, panic, greed, and other emotions that have nothing to do with fundamentals drive markets daily.
That’s why behavioral finance is so important. It combines psychology, economics, and finance to explain why investors make irrational financial decisions. It also highlights the dangers of biases like these:
- Confirmation Bias: Looking for data confirming a belief and ignoring data contradicting one. We tend to put more weight on what we believe versus what we do not.
- Loss Aversion Bias: Preference to avoiding losses as opposed to achieving gains. This is why investors hold their losers even if the odds of recovery are low.
- Self-Control Bias: Taking on too much risk for short-term returns vs. lower risk to achieve the long-term goal of financial freedom.
- Recency Bias: Placing more importance on recent events over historical ones simply because they are top of mind.
- Mental Accounting Bias: Treating money from one source differently than others. For example, valuing stocks that were inherited from loved ones as heirlooms.
Equally important to avoiding these traps is recognizing when others are entangled in them. During the Brexit selloff, those who exploited the irrationality likely profited from the fear and panic of others.
And the beauty of their strategy was its simplicity. They did not need to predict the referendum results or spend months developing a proprietary investment thesis. All they had to do was patiently wait for panic to set in.
The bottom line
The red pill may expose the truth, but it won’t protect you. It’s on you to avoid falling prey, so here are three preventative measures any investor can implement starting today.
First, work with a financial advisor and be honest. Either admit to which biases affect you the most or open up and allow your advisor to conduct a proper risk analysis. Most financial goals that aren’t met are because of decisions made during times of extreme stress rather than the stocks in a portfolio. The real value of an advisor is when they act more like your psychiatrist and less like your money manager.
Second, stop watching financial news. These networks do not provide a public service. They are for-profit institutions whose singular objective is to make money for shareholders. Most of their revenue comes from advertising, so they are highly incentivized to attract as many eyeballs and website clicks as possible. They do this by igniting our biases using stories rather than news. If these are fueling investment decisions, the output will likely be just as flawed as the reporting.
Third, read these books in this order. I’ve highlighted five biases, but there are many more. The more familiar you become with common behaviors, the easier it will become to recognize when you have fallen victim to them.
- Your Money & Your Brain – Jason Zweig
- Misbehaving: The Making of Behavioral Economics – Richard Thaler
- Thinking, Fast & Slow – Daniel Kahneman
The bottom line is that financial markets are accountable to Darwin, not Newton. To become a better investor, spend more time on psychology and less on spreadsheets.
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.